![[Leases – Article 5/5] – Transition to IFRS 16](https://zampadebattista.com/app/uploads/2020/06/IFRS-5_5-ARTICLE.png)
This article is relevant to all IFRS preparers, especially those who are parties to lease contracts as lessees.
IFRS 16 ‘Leases’ is mandatory for financial periods beginning on or after 1 January 2019. This means that a company with a 31 December period-end needs to refer to the first date of its financial period before concluding that IFRS 16 is to be applied from the financial year ending 31 December 2019. In other words, a company incorporated on 1 November 2018, with a first reporting period 31 December 2019, is not obliged to apply IFRS 16 during that first period.
Having said this, IFRS 16 may be applied earlier if two conditions are satisfied:
- IFRS 15 ‘Revenue From Contracts With Customers’ has also been implemented by the date of initial application of IFRS 16.
- The early adoption of IFRS 16 is disclosed.
Companies that, under the superseded leases standard IAS 17, were parties to operating leases as lessees, need to be particularly aware of the changes brought about by IFRS 16. Of importance to preparers, are the transitional provisions, included in Appendix C of the standard. The bulk of the Appendix relates to the transition considerations for lessees who previously accounted for operating leases as expenses, and under IFRS 16, need to capitalise their leases. This will be illustrated below.
The lessee has two options for such transition, and the approach chosen needs to be applied consistently. In the following illustration, Company A is a 20-year old company applying IFRS 16 from 2019. It has a 31 December year-end and has never changed its financial periods.
Option 1: Full Retrospective Approach
Under this approach, financial information relating to the prior year – that is, the last year in which IAS 17 was applied, which happens to be the current year’s comparative – needs to be restated to reflect the accounting treatment under IFRS 16.
The difference arising due to the different accounting treatments is recognised through an adjustment in equity at the beginning of the earliest period presented. Therefore, Company A would reflect the adjustment in equity on 1 January 2018.
Under this option, Company A is recalculating existing operating leases as if IFRS 16 existed in the past. The adjustment to equity on 1 January 2018 reflects the pre-2018 changes resulting from recalculation. In fact, the accounting procedure under IFRS 16 causes:
- The derecognition of past rental expenses.
- The recognition of finance costs.
- The recognition of depreciation.
- The recognition of right-of-use assets and lease liabilities.
Option 2: Modified Retrospective Approach
Under the modified retrospective approach, the lessee applies IFRS 16 from the current year. Therefore, Company A reflects any adjustments to equity on 1 January 2019, and does not need to restate the prior year’s financial information.
The lease liability upon transition is measured as the present value of the remaining lease payments. The discount rate is the lessee’s incremental borrowing rate at the date of initial application.
In the case of the right-of-use assets, preparers have two options – that can be applied on a lease-by-lease basis:
Option A: the right-of-use asset is measured as if IFRS 16 had always been applied. As a result, the right-of-use asset will not be equal to the lease liability. The difference is booked to equity at 1 January 2019.
Option B: the right-of-use asset is measured at the amount of the lease liability.
A right-of-use asset accounted for as investment property is measured using the fair value model in IAS 40 from the date of initial application. No adjustments upon transition are required in this respect.
Numerical Example
Company A entered into a 5-year lease agreement on 1 January 2016 in order to use an office. Company A’s incremental borrowing rate is 5% at all points during the lease term. Company A pays €10,000 per annum in advance for rent, with the first payment dated 1 January 2016, and the last one dated 1 January 2020. Company A will be reflecting IFRS 16 as from 2019.
Option 1: Full Retrospective Approach
- Journal entries under IAS 17 ‘Leases’ (2016 to 2018)
1/1/2016
DR Rent 10,000
CR Cash 10,000
Being payment of 2016 rent.
1/1/2017
DR Rent 10,000
CR Cash 10,000
Being payment of 2017 rent.
1/1/2018
DR Rent 10,000
CR Cash 10,000
Being payment of 2018 rent.
- Workings Upon Transition
Working 1: Present Value Of Future Cash Flows
| Year | Cash Flow | DCF @ 5% |
| 0 | 10,000 | 10,000 |
| 1 | 10,000 | 9,524 |
| 2 | 10,000 | 9,070 |
| 3 | 10,000 | 8,638 |
| 4 | 10,000 | 8227 |
| 45,460 |
Working 2: Amortised Cost Schedule
| Bal B/D | Cash | Interest | Bal C/D | |
| 0 | 45,460 | – 10,000 | 1,773 | 37,232 |
| 1 | 37,232 | – 10,000 | 1,362 | 28,594 |
| 2 | 28,594 | – 10,000 | 930 | 19,524 |
| 3 | 19,524 | – 10,000 | 476 | 10,000 |
| 4 | 10,000 | – 10,000 | – | – 0 |
Working 3: Hypothetical Retrospective accounting with IFRS 16 rules
1/1/2016
DR Right-of-use Asset 45,460
CR Cash 10,000
CR Lease Liability 35,460
31/12/2016
DR Finance Cost 1,773
CR Lease Liability 1,773
DR Depreciation (P/L) 9,092
CR Right-of-use Asset 9,092
1/1/2017
DR Lease Liability 10,000
CR Cash 10,000
31/12/2017
DR Finance Cost 1,362
CR Lease Liability 1,362
DR Depreciation (P/L) 9,092
CR Right-of-use Asset 9,092
1/1/2018
DR Lease Liability 10,000
CR Cash 10,000
31/12/2018
DR Finance Cost 930
CR Lease Liability 930
DR Depreciation (P/L) 9,092
CR Right-of-use Asset 9,092
Summary of impact on equity at 1 January 2018:
Pre-2017 aggregate impact of IFRS 16:
IAS 17 accounting:
DR RE 20,000
CR Cash 20,000
IFRS 16 accounting:
DR Right-of-use Asset 27,276
(Initial recognition of €45,460 less two years of depreciation at €9,092 p.a.)
DR Finance Cost 3,135
(The sum of finance cost for 2016 and 2017, that is, €1,773 + €1,362).
DR Depreciation (P/L) 18,184
(Two years of depreciation)
CR Lease Liability 28,594
(Agrees to amortised cost schedule’s balance at end of 2017).
CR Cash 20,000
(The sum of payments made at 1/1/2016 and 1/1/2017).
The adjustment required at 1 January 2018 is as follows:
DR Retained Earnings 1,318
DR Right-of-use Asset 27,276
CR Lease Liability 28,594
2018 (comparative) will reflect the following, apart from the above adjustment to equity:
Right-of-use Asset 18,184
(The adjustment at 1/1/2018 of €27,276 less 2018’s depreciation of €9,092).
Lease Liability 19,524
(Agrees to amortised cost schedule’s balance at end of 2018).
Finance Cost 930
(Agrees to amortised cost schedule’s finance cost for 2018).
Depreciation (P/L) 9,092
(One year’s depreciation).
- Journal entries under IFRS 16 ‘Leases’ (2019 and 2020)
1/1/2019
DR Lease Liability 10,000
CR Cash 10,000
31/12/2019
DR Finance Cost 476
CR Lease Liability 476
DR Depreciation (P/L) 9,092
CR Right-of-use Asset 9,092
1/1/2020
DR Lease Liability 10,000
CR Cash 10,000
31/12/2020
DR Depreciation (P/L) 9,092
CR Right-of-use Asset 9,092
Option 2: Modified Retrospective Approach With Right-of-use Asset Triggering Equity Adjustment On Transition
Lease Liability at 1/1/2019 19,524
Right-of-use Asset at 1/1/2019 18,184
Equity Adjustment at 1/1/2019 1,340
The financial statements for 2019 will show an adjustment to the opening equity amount for 2019, amounting to €1,340. The comparatives (2018) are unchanged.
Option 2: Modified Retrospective Approach With Right-of-use Asset Not Triggering Equity Adjustment On Transition
Lease Liability at 1/1/2019 19,524
Right-of-use Asset at 1/1/2019 19,524
Equity Adjustment at 1/1/2019 0
The financial statements for 2019 will show no adjustment to the opening equity amount for 2019. The comparatives (2018) are unchanged.
In the meantime, should you require any assistance or advice on the subject, please contact:
John Debattista – Partner jd@zampadebattista.com
Paul Zammit – Technical assistant manager pz@zampadebattista.com
Rebecca Marie Bezzina – Technical assistant rmb@zampadebattista.com
For any assistance on IFRS or GAPSME-related matters, please email ifrshelpdesk@zampadebattista.com
DISCLAIMER: Please note that this article is being published for information purposes only. As such it does not constitute or is to be interpreted or construed as legal advice or guidance. Zampa Debattista does not accept responsibility for or be liable to any damages arising as a result of using this information as legal advice or guidance.