Understanding IFRS 16: A Beginner's Guide to Lease Accounting

 

Welcome to a quick and easy-to-understand guide on IFRS 16, the standard that governs how leases should be recorded and disclosed in financial statements. If you’re new to accounting or just want a simple rundown, this tutorial covers the basics, breaking down how both lessees (those who lease assets) and lessors (those who provide assets for lease) should handle leases in their books. Plus, we’ll walk through an example that makes it all make sense.

 

What is IFRS 16?

In simple terms, IFRS 16 is an international accounting standard that explains how companies should recognize, measure, present, and disclose leases. Under IFRS 16, companies leasing assets (lessees i.e., the users of the leased assets) must recognize almost all leases on their balance sheets. They show these as assets they have the right to use, paired with liabilities for the payments they need to make.

Key Points to Remember:

1. Lessees must recognize an asset and liability for almost all leases (with some exceptions).

2. Lessors (i.e., the providers of the leased assets) still classify leases as finance leases or operating leases, with little change from the old standard (IAS 17).

 

What’s Covered and What’s Exempt?

IFRS 16 applies to most lease types but has some exceptions:

Some Leases are excluded from this standard. These are leases of natural resources, biological assets, service concessions, and certain intellectual property rights.

In the same vein, there are some exemptions to the leases covered under this standard. These are:

    1. Short-term leases (12 months or less, with no purchase option)

    2. Low-value assets (e.g., laptops or office chairs)

For these exempt leases, lessees can simply treat lease payments as expenses rather than showing them on the balance sheet.

 

The Accounting Process: Lessee and Lessor

Let’s break it down for both the lessee (asset user) and the lessor (asset provider).

1. Accounting by Lessees

As the lessee, IFRS 16 requires you to recognize:

   1. A Right-of-Use Asset (RoU Asset) – representing your right to use the asset.

   2. A Lease Liability – representing your obligation to make lease payments.

Here’s the step-by-step process:

1. Initial Measurement:

At initial recognition (i.e., at the very first time you want to record the lease transaction in your books as a lease), calculate the Lease Liability as the present value of future lease payments, discounted by the interest rate implicit in the lease or, if unknown, your incremental borrowing rate.

Simultaneously, recognize the Right-of-Use Asset as the sum of:

     - Lease liability

     - Initial direct costs

     - Prepaid lease payments (if any)

     - Restoration costs (if applicable).

2. Subsequent Measurement:

Subsequent to initial recognition (i.e., possibly the following month or year after the first time the lease was recorded in your books), depreciate the Right-of-Use Asset over the lease term.

In the same vein, adjust the Lease Liability for interest expense and lease payments.

 

Example for Lessee Accounting

Michael Jackson Limited signs a lease for office equipment (with book value of $10,000) on January 1, 2023, from Isaac Jones Limited with the following terms:

   - Lease Term: 3 years

   - Annual Payment: $5,000

   - Discount Rate: 5%

A. In the Books of Michael Jackson Limited (i.e., the Leasee)

Step 1: Calculate the Lease Liability.

Using a 5% discount rate, the present value (PV) of future payments:

  Lease Liability = 5,000 × ((1−(1+0.05)⁻³​)/0.05) = 5,000 × 2.723 = $13,615

Step 2: Record the Right-of-Use Asset.

   Right-of-Use Asset=Lease Liability = $13,615

 Step 3: Book Entry at Inception:

   - Dr Right-of-Use Asset: $13,615

   - Cr Lease Liability: $13,615

Step 4: Annual Depreciation (Subsequent to Initial Recognition):        

Subsequent to inception, calculate depreciation expense as follows:

   - Depreciation Expense = Right-of-Use Asset / Lease Term = $13,615 / 3 = $4,538.33 per year.

 

2. In the Books of Isaac Jones (i.e., The Leasor):

Lessors classify leases as either finance leases (where they transfer ownership-like benefits and risks) or operating leases (where they don’t). Let’s look at the treatment for both types.

   - Finance Lease: The lessor records a receivable equal to the net investment in the lease (present value of lease payments).

   - Operating Lease: The lessor keeps the asset on their balance sheet and recognizes lease income over the lease term.

In the case of the above example involving Michael Jackson Limited and Isaac Jones Limited, if Isaac Jones classifies the lease as an Operating Lease, the accounting entry is as follows:

Since this is an operating lease:

   - No asset transfer means Isaac Jones keeps the property on its balance sheet.

   - It also recognizes lease income of $5,000 each year.

Therefore,

   - Dr Cash : $5,000

   - Cr Lease Income: $5,000

Still using the above example involving Michael Jackson Limited and Isaac Jones Limited, if otherwise Isaac Jones classifies the lease as a Finance Lease, the accounting entry is as follows:

Since this is a finance lease:

   - It means the asset (i.e., office equipment) is transferred by Isaac Jones therefore it can no longer keep the property on its balance sheet. But instead a receivable equal to the net investment in the lease (present value of lease payments) is recognized in its balance sheet.

   - It also recognizes lease income of $5,000 each year.

Therefore,

  At Lease Commencement:

-          Debit Lease Receivable (for the net investment): $13,615

-          Credit Leased Asset: $13,615

-          Credit Unearned Interest Income (difference): $3,615 (i.e., $13,615 - $10,000)

  For Each Lease Payment Received:

-          Debit Cash (or Bank)

-          Credit Lease Receivable (reducing the receivable balance)

-          Credit Interest Income (for the finance income portion)

Quick Recap: Key Points

- For Lessees: Almost all leases go on the balance sheet as assets and liabilities. Use discount rates for present value and depreciation for Right-of-Use Assets.

- For Lessors: Classify leases as finance or operating. Finance leases remove the asset but create a receivable; operating leases keep the asset and record income.

 

Wrapping Up

IFRS 16 aims to give a clearer picture of leasing obligations and rights for both lessees and lessors. By bringing leases onto the balance sheet, it allows users of financial statements to see the full scope of a company’s leasing activities. Hopefully, this breakdown makes IFRS 16 a bit less intimidating. Just remember the basics, and with a little practice, you’ll have the hang of lease accounting in no time!

But for those preparing for professional examinations, watch out for detailed examples with solutions.