1. What is IFRS 16?
IFRS 16 is an International Financial Reporting Standard issued by the International Accounting Standards Board (IASB). It focuses on how companies should account for leases in their financial statements.
A lease is any agreement where one party (the lessee) pays another party (the lessor) for the use of an asset, like office space, equipment, or vehicles, over a period.
2. A Quick Look Back: IAS 17
Before IFRS 16, leases were accounted for under IAS 17. IAS 17 required leases to be classified as either operating leases or finance leases:
Operating Leases
An operating lease is a lease whereby the lessor does not transfer all the risks and rewards of ownership of the asset to the lessee. The implication of this is that the lessor retains ownership of the asset (i.e., the lessor still reports the asset on their balance sheet). And because the lessor retains ownership, the lessor is under obligation to pay such cost as insurance, maintenance and similar charges on the asset.
On the other hand, the lessee treats the lease as a mere rental of the asset and records only the rent as an expense on their statement of profit or loss.
Finance Leases
A finance lease is a lease whereby the lessor transfers substantially all the risks and rewards of ownership of the asset to the lessee. The implication of this is that the lessor does not retain ownership of the asset and no longer reports the asset on their balance sheet. Instead, the leased asset is replaced with another asset called lease receivable (i.e., periodic payment expected from the lessee for using the asset). And because the lessor does not retain ownership of the asset, it is the lessee that is under the obligation to pay such cost as insurance, maintenance and similar charges on the asset.
On the other hand, the lessee treats the lease as though they bought the asset on loan and records it as an asset in their balance sheet. The lessee also records a liability on their balance sheet to show that they owe the lessor periodic payments for the asset. This liability is called lease liability.
- Transfer of Ownership: Ownership of the asset transfers to the lessee by the end of the lease term.
- Bargain Purchase Option: The lessee has an option to purchase the asset at a price significantly lower than the asset’s fair value.
- Lease Term: The lease term covers the majority of the asset’s economic life.
- Present Value: The present value of lease payments amounts to substantially all of the asset’s fair value.
- Specialized Asset: The asset is of such a specialized nature that only the lessee can use it without significant modifications.
The Problem with IAS 17
How IFRS 16 Fixes the Problem With IAS 17
- All leases must now be recognized on the lessee's balance sheet - no more hiding operating leases.
- Lessees must show: (a) A right of use (ROU) asset, which represents their right to use the leased asset for the duration of the lease; and (b) A lease liability, which represents the lessee's obligation to make future payments for the lease.
3. Understanding the Basics: What is a Lease?
A lease is a contract that allows one party (lessee) to use an asset owned by another party (lessor) for a specific period in exchange for regular payments.
For example, if a company (the lessee) leases a piece of machinery for 5 years, the contract gives them control over the machinery for that 5 years, in exchange for paying the agreed amount each year or month to the lessor.
4. Identifying a Lease
Before applying IFRS 16, one must ensure that the contract is indeed a lease. A contract contains a lease if it meets three criteria:
- Identified Asset: There is a specific asset being leased.
- Right to Use: The lessee has the right to use the asset.
- Economic Benefits: The lessee can obtain most of the economic benefits from using the asset.
5. Accounting for LESSEES Under IFRS 16
a. Initial Recognition and Measurement for Lessee
When a lease is identified, the lessee needs to recognize both the ROU asset and the lease liability on the balance sheet.
Step 1. Calculating the Lease Liability
Lease Liability is the present value of all future lease payments. To calculate this, we need to understand the time value of money.
Time Value of Money Explained: Money available now is worth more than the same amount in the future because of its potential earning capacity. This concept is crucial in calculating the present value of future lease payments.
Formula for Present Value (PV):
- P = Payment per period
- r = Discount rate (interest rate)
- n = Number of periods
Example Calculation: ABC Ltd. leases a truck for 3 years with annual payments of ₦500,000. Assume the discount rate is 5%.
Year 1:
Year 2:
Year 3:
Total Present Value (Lease Liability):
So, ABC Ltd. records a lease liability of ₦1,361,527.
Step 2. Recognizing the Right-of-Use Asset
The ROU Asset is initially measured at the same amount as the lease liability, plus any initial direct costs (like legal fees) and prepaid lease payments, minus any lease incentives received.
Initial ROU Asset = Lease Liability + Initial Direct Costs + Prepaid Payments - Lease Incentives
For simplicity, assuming no initial direct costs, prepaid payments, or incentives:
b. Subsequent Measurement for Lessee
After the initial recognition, both the lease liability and the ROU asset are updated over time.
Step 1. Lease Liability
The lease liability is reduced by the lease payments made and increased by interest expense.
Interest Expense Calculation:
Interest = Lease liability × Interest rate (r)
Year 1:
Continuing from the previous example,
Interest = ₦1,361,527 × 0.05 = ₦68,076
Lease payment = ₦500,000
As each lease payment is made, part of that payment goes towards paying off the principal (reducing the lease liability) and part goes towards paying the interest (cost of borrowing). This means that the ₦500,000 payment above is inclusive of ₦68,076, because it contains both the principal element and the interest element.
Ordinarily, since a portion of the total lease liability has been paid, we reduce the total lease liability by that portion, which is ₦500,000. However, we are only allowed to deduct the principal element from the lease liability and not the interest element. We need to include the interest element as part of the liability because it represents the cost of carrying that debt.
Hence, subtracting the interest element from the lease payment, we have: ₦500,000 - ₦68,076 = ₦431,924
New lease liability = ₦1,361,527 - ₦431,924 = ₦929,603
Which means that the new lease liability to be recorded in the company's balance sheet in the first year of payment is ₦929,603.
Repeat the process for other years.
Step 2. Right-of-Use Asset
The ROU asset is depreciated over the lease term.
Depreciation Calculation:
This means that every year, we decrease the ROU asset by ₦453,842, until the lease term is over.
Year 1:
ROU asset (End of year) = ₦1,361,527 - ₦453,842 = ₦907,685
The following year, we decrease ₦907,685 by ₦453,842, and so on until the lease term is over, when the ROU asset will be fully depreciated.
c. Lease Modifications for Lessee
Sometimes, lease terms change. For example, at the end of year 1, ABC Ltd. might decide to extend the truck lease for an additional 2 years at ₦400,000 per year.
Recalculating Lease Liability:
New Payments:
- Year 4: ₦400,000
- Year 5: ₦400,000
Present Value of New Payments: Assuming the discount rate remains 5%, calculate the present value for year 4 and 5.
Update Lease Liability:
New lease liability at the end of year 1 = Existing lease liability + New PV
From our previous calculations, existing lease liability (at the end of year 1) = ₦929,603
Hence, new lease liability at the end of year 1 = ₦929,603 + ₦743,766 = ₦1,673,369
Update ROU Asset:
New ROU asset at the end of year 1 = Existing value of ROU asset + New PV
From our previous calculations, existing value of ROU asset (at the end of year 1) = ₦907,685
Hence, new lease liability at the end of year 1 = ₦907,685 + ₦743,766 = ₦1,651,451
d. Presentation and Disclosure for Lessee
On the Balance Sheet:
- ROU Asset: Listed under non-current assets.
- Lease Liability: Split into current (due within a year) and non-current liabilities.
In the Notes:
- Nature of Leases: Describe the types of leases (e.g., trucks, office space).
- Future Lease Payments: Provide a schedule of future payments.
- Assumptions: Disclose the discount rate used and any judgments made.
6. Accounting for LESSSORS Under IFRS 16
Under IFRS 16, lessors classify leases into two main categories:
- Operating Leases
- Finance Leases
This classification is similar to the previous standard (IAS 17), ensuring continuity for lessors. The classification depends on the extent to which the lease transfers the risks and rewards of ownership of the asset to the lessee.
a. Operating Leases - Step by Step
Step 1: Initial Recognition
- Asset on Balance Sheet: The leased asset remains on the lessor’s balance sheet.
- Depreciation: The lessor continues to depreciate the asset as per their depreciation policy.
Step 2: Lease Payments
- Rental Income: Lease payments received are recognized as rental income on a straight-line basis over the lease term unless another systematic basis is more representative.
Example: Let's say a company, ABC Leasing leases out a truck for ₦30,000,000 per year for three years.
- Annual Rental Income: ABC Leasing recognizes ₦30,000,000 each year as rental income.
- Asset Depreciation: If the truck's cost is ₦90,000,000 and it has a useful life of 6 years, ABC Leasing depreciates it at ₦15,000,000 per year (i.e., ₦90,000,000 ÷ 6).
Step 3: End of Lease
- Asset Ownership: The truck remains with ABC Leasing unless there's a purchase option exercised by the lessee.
b. Finance Leases - Step by Step
Step 1: Initial Recognition
- Remove Asset: The lessor removes the leased asset from their balance sheet.
- Recognize Lease Receivable: The lessor records a lease receivable equal to the present value of future lease payments.
Step 2: Lease Payments
- Interest Income: Part of each lease payment is recognized as interest income.
- Reduction of Lease Receivable: The remaining part of the lease payment reduces the lease receivable.
Example: Let's say LMN Equipment leases a machine to Global Manufacturing for five years at ₦50,000,000 per year. The machine’s fair value is ₦200,000,000 and the present value of lease payments is calculated to be ₦180,000,000.
- Initial Recognition:
- Remove machine from balance sheet.
- Record lease receivable of ₦180,000,000.
- Annual Lease Payment of ₦50,000,000:
- Interest Income: Suppose the implicit rate is 5%. First year's interest = ₦180,000,000 * 5% = ₦9,000,000.
- Reduction of Receivable: ₦50,000,000 - ₦9,000,000 = ₦41,000,000. Therefore, ₦41,000,000 will be deducted from the lease receivable, ₦180,000,000 in the first year. Hence, at the end of the first year, the lease receivable will be ₦180,000,000 - ₦41,000,000 = ₦139,000,000.
- Subsequent Years: The lease receivable at the beginning of the second year is ₦139,000,000, as calculated above. Note that the lease receivable decreases as payments are made, and interest income is recalculated based on the remaining receivable as done above.
Step 3: End of Lease
- Ownership Transfer: If there’s a bargain purchase option, the lessee may purchase the asset, finalizing the finance lease.
c. Initial Direct Costs for Lessors
Lessors may incur initial direct costs to arrange a lease, such as commissions or legal fees. Under IFRS 16:
- Operating Leases: Initial direct costs are recognized as an asset and amortized over the lease term.
- Finance Leases: Initial direct costs are deducted from the lease receivable at the commencement of the lease.
Example (operating leases): In the previous example on operating leases, let's assume ABC Leasing spends ₦3,000,000 on legal fees to set up the truck lease for 3 years.
- Operating Lease Treatment:
- Recognize ₦3,000,000 as an asset.
- Amortize ₦1,000,000 each year over three years (i.e., ₦3,000,000 ÷ 3).
Example (finance leases): In the previous example on finance leases, LMN Equipment spends ₦5,000,000 on commissions for the machine lease.
- Finance Lease Treatment:
- Deduct ₦5,000,000 from the initial lease receivable of ₦180,000,000.
- Lease receivable becomes ₦175,000,000 (i.e., ₦180,000,000 - ₦5,000,000).
d. Variable Lease Payments
IFRS 16 distinguishes between fixed and variable lease payments.
- Fixed Lease Payments: Payments are set and do not vary based on future events.
- Variable Lease Payments: Payments vary based on factors like usage or performance.
For Lessors:
- Operating Leases: Variable lease payments not linked to an index or rate are recognized in the period they are incurred.
- Finance Leases: Only fixed payments and variable payments based on an index or rate are included in the lease receivable.
Example: ABC Leasing includes maintenance costs based on usage in the truck lease. These variable payments are recognized as rental income when incurred.
e. Sale and Leaseback Transactions
A sale and leaseback occurs when a lessor sells an asset and immediately leases it back from the buyer.
IFRS 16 Treatment:
- Determine if it's a genuine sale: Determine whether control of the asset has been transferred to the buyer.
- Accounting: Recognize any gain or loss from the sale, considering any lease incentives.
Example: XYZ Corporation sells a building to Real Estate Ltd. and immediately leases it back.
- Sale Recognition: XYZ recognizes the sale proceeds and removes the building from its balance sheet.
- Leaseback Accounting: Depending on lease classification, XYZ accounts for the lease under IFRS 16 guidelines as described in previous paragraphs above.
f. Disclosure Requirements for Lessors
IFRS 16 mandates that lessors provide specific disclosures to enhance transparency:
- Lease Classification: The nature and extent of leases classified as operating or finance leases.
- Lease Terms: Information about lease terms, options to extend or terminate, and significant restrictions imposed by leases.
- Financial Impact: Details about lease receivables, interest income, and any residual asset rights.
Example: LMN Equipment must disclose:
- The total value of lease receivables.
- The interest income recognized from finance leases.
- Details about significant lease terms, such as options to purchase.
g. Differences Between IFRS 16 and Previous Standards (IAS 17) for lessor accounting
Understanding the shift from IAS 17 to IFRS 16 can clarify lessor accounting changes:
- Continuing Classification: IFRS 16 maintains the same classification for lessors as IAS 17 (operating vs. finance leases).
- Enhanced Disclosure: IFRS 16 requires more detailed disclosures, improving transparency.
- Recognition of Lease Receivables: For finance leases, IFRS 16 provides clearer guidance on recognizing and measuring lease receivables.
Under IAS 17, lessors might have had more flexibility in classification. IFRS 16 standardizes certain aspects, ensuring consistency in financial reporting.