Example: How to Adopt IFRS 16 Leases

In my last article I tried to outline the strategy and your choices when implementing the new lease standard IFRS 16 Leases.

I am grateful for many responses and comments I got from you. Almost all e-mails I received from you asked me to publish solved numerical example to see how to implement IFRS 16 in practice.

Therefore, unlike in my other usual articles, this time I’ll solve one example with one specific lease contract for you.

You might well know that the IFRS 16 affects mostly lessees who are involved in operating leases, because under the new rules they need to bring the assets from off-balance sheet to the daily light.

In other words, they will no longer be permitted to book all rental expenses from operating leases in profit or loss, but they will need to recognize the lease liability and the right of use asset.

Therefore, in this article, I illustrate the application of the full retrospective approach and modified retrospective approach to IFRS 16 adoption.

Ready for the example? Here you go!
 

Example: Operating lease in the lessee’s accounts under IFRS 16

ABC, the manufacturing company, needs to adopt the new standard IFRS 16 Leases in the reporting period ending 31 December 2019.

During the preparatory works, ABC discovered that the operating lease contract related to a machine might require some adjustments.

ABC entered into the contract on 1 January 2017 for 5 years, annual rental payments are CU 100 000 in arrears (that is, 31 December each year) and at the end of the lease term, the machine will be returned back to the lessor. The economic life of a machine is 10 years.

Use the discount rate of 3%.
 

Little note about the discount rate

If you are a lessee, then be careful about the selection of the appropriate discount rate, because its definition in IAS 17 no longer applies.

Here, the new definition in IFRS 16 says that you should derive the interest rate implicit in the lease from:

• The lease payments,
• The unguaranteed residual value,
• The fair value of the underlying asset and
• The initial direct costs of the lessor.

This is very hard and sometimes unrealistic, because most lessors won’t share the unguaranteed residual values and their initial direct costs.

Therefore, most lessees will need to use the incremental borrowing rate – that is, the rate at which they would be able to get the new borrowings for acquisition of the same asset with similar terms.

This is quite judgmental, but at least it’s more realistic than asking your lessor for additional information in most cases.

In this numerical example, let’s assume that given 3% is the ABC’s incremental borrowing rate.
 

Presenting the contract under IAS 17 and IFRS 16

Before you start drafting your journal entries to adopt IFRS 16 and cease reporting the contract under IAS 17, you need to see clearly how you reported that contract under both sets of rules.
 

Operating lease contract under IAS 17

Here, it’s very simple and straightforward: ABC accounted for all the lease payments from the operating lease directly in profit or loss.
 

Operating lease contract under IFRS 16

Under IFRS 16, ABC needs to recognize the right of use asset and the lease liability.

The lease liability is calculated as all the lease payments not paid at the commencement date discounted by the interest rate implicit in the lease or incremental borrowing rate.

I have done that for you in the following table:
 

 
Note: Discount factor in the first year is calculated as 1/((1+3%) to the power of year 1), etc.

Fine, we have the lease liability.

The right of use asset equals to the lease liability at the commencement date, plus lessee’s initial direct costs, plus some other things – but in this case, we have nothing like that, so let’s just say it’s the same as the lease liability.

Under IFRS 16, the initial journal entry would be:

• Debit ROU (right of use) asset: CU 457 971

• Credit Lease liability: CU 457 971

Subsequently, ABC needs to take care about 2 things:

1. Depreciation of the ROU asset: Let’s say it’s straight line over the lease term of 5 years, thus it’s CU 91 594 per year (CU 457 971/5).
2. Lease payments: Each lease payment of CU 100 000 is split between the repayment of the lease liability and interest.

I’ve done that in the following table:
 

Compare the accounting under IAS 17 and IFRS 16

To calculate the adjustment in equity related to this contract, let’s summarize the profit or loss impact of the lease in individual years under both IAS 17 and IFRS 16:
 

 
As you can see, total profit or loss impact of both IAS 17 and IFRS 16 application is the same CU 500 000, however, the timing is a bit different.

So, now we have set everything and let’s see how to make adjustment in equity and how to present the restatement under both full and modified retrospective approaches.

I described both approaches in this article, so I won’t repeat it here and let me focus on numbers.
 

Full retrospective approach

ABC adopts IFRS 16 in its financial statements for the year ending 31 December 2019, and that means that the transition date is 1 January 2018.

We need to restate all numbers for the comparative period, too.

Most of the work has been done above (see tables 1-3), so I’ll draft the journal entries here:

1. Restatement of opening balances of the earliest period presented (that is: BEFORE 1 January 2018):
   • a) Recognizing ROU asset and lease liability:

     • Debit ROU (right of use) asset: CU 457 971

     • Credit Lease liability: CU 457 971

   • b) Reversal of the lease payments before 1 January 2018 under IAS 17 (there was just one):

     • Debit Cash: CU 100 000

     • Credit Retained earnings (equity): CU 100 000

     I know, I know! No cash moved! Wait until we are done with this exercise. This is just to illustrate that in fact, you are reversing the “old entries” and then making the “new entries”.

     And why retained earnings and not profit or loss?

     Because you are making this entry on 1 January 2018 and at this date, all profit or loss accounts from 2017 were transferred to the retained earnings.

   • c) Accounting for the lease payments before 1 January 2018 under IFRS 16 (there was just one):

     • Debit Lease liability: CU 86 261

     • Debit Retained earnings (equity): CU 13 739 – this is for the interest

     • Credit Cash: CU 100 000

     Note: The numbers come from table 2 for the year 1 (2017).

   • d) Accounting for the depreciation of the ROU asset before 1 January 2018 under IFRS 16 (there was just one year):

     • Debit Retained earnings (equity): CU 91 594

     • Credit ROU asset: CU 91 594

   In fact, you can do all 4 entries in one adjustment and it would look something like:

   • Debit ROU asset: CU 366 377 (CU 457 971 less depreciation of CU 91 594)

   • Debit Retained earnings in equity: CU 5 333 (-100 000+13 739+91 594, or see table 3 for the year 1)

   • Credit Lease liability: CU 371 710 (CU 457 971 less the lease liability repayment of CU 86 261, or see table 2 for the year 1)

   In reality, you would adjust in in 1 single entry, but I wanted to show the rationale behind, its breakdown and logic.

2. Restatement of the comparative period (year 2018):

   Here, you are only restating the 2nd lease payment made. As I’ve illustrated the breakdown of all entries above, let me show you just one summarizing entry here:

   • Debit Lease liability: CU 88 849

   • Debit Interest (profit or loss of 2018): CU 11 151

   • Debit Depreciation (profit or loss of 2018): CU 91 594

   • Credit ROU asset: CU 91 594

   • Credit Operating lease expenses (profit or loss of 2018): 100 000

   The numbers come from table 2 for the year 2 (2018).

3. Restatement of the current period (year 2019):

   Normally, you would have already applied IFRS 16 in 2019, but if not and you are doing everything during the closing works, here’s the entry:

   • Debit Lease liability: CU 91 514

   • Debit Interest (profit or loss of 2019): CU 8 486

   • Debit Depreciation (profit or loss of 2019): CU 91 594

   • Credit ROU asset: CU 91 594

   • Credit Operating lease expenses (profit or loss of 2019): 100 000

OK, that’s for the entries and adjustments.

• In the financial statements for the year ended 31 December 2018, you are still applying IAS 17, so your current numbers for 2018 are under IAS 17, but
• In the financial statements for the year ended 31 December 2019, you apply the new IFRS 16 and also your comparatives need to be stated under the same rules – thus you need to book the above entries n. 1 and n.2 carefully.

How would your financial statements look like?

Here you go:

The statement of financial position (extract) is here:
 

 
All the numbers related to the lease liability come from table 2 above.

The extract from profit or loss statement:
 

 
Now, let’s show the modified approach.
 

Modified retrospective approach

Under the modified approach, ABC needs to make an equity adjustment on 1 January 2019 – that is at the beginning of the current reporting period.

Comparative numbers remain the same as presented before – so no restatement.

This is a way easier method to apply than the full retrospective approach, because you do not restate the previous years’ numbers.

However, the price for this relief is lower comparability.

It is quite difficult to compare current year under IFRS 16 with the previous year under IAS 17 and it does not say much about how your leases developed.

Just see it for yourself in the below extracts from the financial statements.

Before you jump into the journal entries, please note that I assumed the same discount rate at the date of application as original discount rate – just for the sake of this example, because thus I don’t need to recalculate the amounts from full approach.

In reality, you need to measure the lease liability under modified retrospective approach as present value of the remaining lease payments discounted by the rate at the initial application. You can revise the same example taking different discount rates into account here.

In this example, lease liability is effectively measured as present value of the remaining lease payments discounted by the original discount rate (as taken from above).

Let’s draft the journal entries:

1. Restatement of opening balances at 1 January 2019:
   • a) Recognizing ROU asset and lease liability:

     • Debit ROU (right of use) asset: CU 457 971

     • Credit Lease liability: CU 457 971

   • b) Reversal of the lease payments before 1 January 2019 under IAS 17 (there were two):

     • Debit Cash: CU 200 000

     • Credit Retained earnings (equity): CU 200 000

   • c) Accounting for the lease payments before 1 January 2019 under IFRS 16 (there were two):

     • Debit Lease liability: CU 175 110

     • Debit Retained earnings (equity): CU 24 890 (= interest)

     • Credit Cash: CU 200 000

     Note: The numbers come from table 2 for the years 1 and 2 – you need to make a total for these 2 years (2017 and 2018).

   • d)Accounting for the depreciation of the ROU asset before 1 January 2019 under IFRS 16 (there were 2 years):

     • Debit Retained earnings (equity): CU 183 188

     • Credit ROU asset: CU 183 188

   Similarly as with the full approach, you can make just one aggregate entry instead of these four:

   • Debit ROU asset: CU 274 782 (CU 457 971 less depreciation of CU 91 594*2)

   • Debit Retained earnings in equity: CU 8 079 (-200 000+24 890+183 188, or see table 3 for the years 1 and 2)

   • Credit Lease liability: CU 282 861 (CU 457 971 less the lease liability repayments of CU 86 261 and CU 88 849, or see table 2 for the years 1 and 2)

Note: Here, I measured the ROU asset as if IFRS 16 has always been applied – in this case, it was easier for me as I have already calculated all the numbers above.

However, you can measure your ROU asset in the amount of the lease liability. This would be even easier, because you would not have to recalculate ROU asset in the past. You would simply calculate the lease liability (=present value of the remaining lease payments) and that’s it.

2. Restatement of the current period (year 2019):

   It’s the same as under the full retrospective approach and if you have accounted for your operating leases under IAS 17 during the whole 2019, then you need to do this adjustment:

   • Debit Lease liability: CU 91 514

   • Debit Interest (profit or loss of 2019): CU 8 486

   • Debit Depreciation (profit or loss of 2019): CU 91 594

   • Credit ROU asset: CU 91 594

   • Credit Operating lease expenses (profit or loss of 2019): 100 000

What about the ABC’s financial statements?

Here you go:

The extract from the statement of financial position:
 

 
Please note that there are zeros for the comparative year 2018 – the reason is obvious. We are presenting the previous year under IAS 17 and there was no lease liability and right of use asset under IAS 17.

The extract from profit or loss:
 

 
This was just a basic example with a very simple and straightforward contract. If you’d like to learn more about IFRS 16, its application, adoption and see many practical examples solved in Excel, then I recommend checking out my IFRS Kit – IFRS 16 is extensively covered!

Also, here’s the same example illustrating different transition options and practical expedients, so check it out.

Any questions or comments?

Let me know below – thanks!