Complying with IFRS 16 – Lease Accounting

ifrs-16-lease-compliance-triniti

Triniti helped multiple entities in the middle east transition from IAS 17 to IFRS16. For lessees, the changes introduced by IFRS 16 are significant with the requirement to bring all leases onto the balance sheet. Though IFRS16 coverage is far and wide, and some aspects of application require the exercise of judgment, this note serves as a quick reference on how to account for the ‘right of use’ asset and the related lease liability.

A Brief Overview

Effective from 1st Jan 2019, International Accounting Standards Board (IASB) brought in new accounting legislation to revamp the accounting representation of Leases. This significant lease accounting change in over three decades impacts every company with leased assets reporting under IFRS16. Companies can no longer book their Operating lease expenses to Profit and Loss Statement alone. The leased assets would now appear in the Balance Sheet in Right of Use Assets and Lease Liabilities—increasing the recognized assets and liabilities. Also, the new standard recognizes more lease expenses in the early period of a lease and less in the later periods affecting the P&L statement and the majority of financial ratios and metrics.

Use Case – Accounting Considerations in Old and New Standard

Let us understand this standard with a use case in old and new standards. Consider a lessee acquiring a new building on a lease basis on an annual rent of Saudi Riyal (SAR) 120,000 per annum for a contract term of 10 years. It translates to an obligation of SAR 10,000 per month for a tenure of 120 months, amounting to a total lease obligation of SAR 1,200,000.

Accounting as per IAS 17 - Old Standard:

The lessee would mark SAR 10,000 as the lease expense per month throughout the lease tenure, amounting to SAR 1,200,000 for ten years. The accounting representation would go as follows:

Lease Expense Accounting Entry	Dr	Cr
Lease Expense A/c Dr	10,000
To Cash A/c Cr		10,000

Accounting as per IFRS 16:

The lessee should now discount all the lease cash flows (SAR 1,200,000 in total) to present value (SAR 797,144) using a discount rate (10% as an example) and create Right of Use Asset (SAR 797,144) and Lease Liability (SAR 797,144) in the balance sheet. The accounting representation would go as follows:

Lease Booking Entry	Dr	Cr
ROU A/c Dr	797,144
To Lease Liability A/c Cr		797,144

You have to amortize the ROU on a straight-line basis over the tenure of the lease. It would bring ROU Balance to zero at the end of the lease term. The monthly accounting entry for amortization expense is:

Amortization Entry	Dr	Cr
Amortization A/c Dr	6,643
To ROU A/c Cr		6,643

You also add the interest back to the discounted value of Lease Liability to match it to actual lease payments. Below is the monthly accounting entry for interest accrual:

Interest Entry	Dr	Cr
Interest A/c Dr	5,774
To Lease Liability A/c Cr		5,774

The Lease balance would come down with each payment made to the lessor. It would become zero once all the lease payments are honored. Accounting entry for the charges against the lease is as follows:

Payment Entry	Dr	Cr
Lease Liability A/c Dr	10,000
To Cash A/c Cr		10,000

Impact of IFRS16 on Profitability of the Lessee

From the above illustrations, it is evident that overall lease expense for the complete tenure of a lease is similar under new and old standards. But the representation of Expenses would be different under different heads. The front-loaded finance charges increase Expenses significantly in the initial tenure of the lease and reduce the same during the later years. Hence, IFRS 16 shows lower profitability of the lessee in the initial years of implementation and compensates the same during later years.

Exemptions from IFRS16

IFRS 16 doesn’t affect those leases that are either short-term (less than 12 months) or those whose value is insignificant (value is less than or equal to USD 5000), then those leases are exempted from IFRS 16.

Refer to this source for an exhaustive guide to IFRS 16.