Adopting IFRS 16 – What Is The Best Option For You?
The standard IFRS 16 Leases has been issued for a while with the mandatory effective date of 1 January 2019.
It means that you should have done some work and have it in function by this time.
Yet, I still keep receiving questions related to different transition approaches, something like:
“Is it possible that the transition to IFRS 16 has no impact on our equity?”
“Does the lease liability need to be different from right-of-use asset and why?”
However, it is true that the new IFRS 16 permits more than one method of implementing IFRS 16 and it is up to you to choose the one and follow it.
It is also true that your results, including the impact on equity, directly depend on the method that you choose.
How many options are there?
Well, actually it is hard to say.
The reason is that IFRS 16 contains TWO basic transition approaches and A FEW practical expedients (certain exceptions) that you can apply optionally on top of your selected transition approach.
So, if you combine application of individual transition approaches with practical expedients, there are indeed many options.
Here I would like to outline a few decisions that you may need to make in order to select the best option for you.
Decision #1: Should we reassess all the lease contracts existing prior adoption of IFRS 16?
Here, you have the first choice.
You can choose either:
- To reassess all your previous contracts and examine whether they contain the lease according to new definition in IFRS 16 or not; or
- To apply practical expedient and not to reassess, but accept the assessment under previous standards.
It can really happen that some contracts that did not contain the lease under older rules will contain the lease under newer rules and vice versa.
For example, imagine that in the past you entered into a long-term contract for the supply of energy and for that purpose, the supplier dedicated some equipment in order to fulfil the contract.
Under IFRIC 4 you might have identified that there was a lease, but under IFRS 16 you concluded that there is no lease because you as a customer could not decide about the use of the equipment (supplier can).
Therefore, if you apply option 1 and reassess, you need to make an adjustment at transition date to stop accounting for that contract as for a lease and start accounting for it as for a service contract.
Or, you can apply option 2, no reassessment and you continue accounting for that contract as for the lease.
Decision #2: Exemption for short-term leases and low value leases?
If you are a lessee, you can apply 2 exemptions related to accounting for leases:
- Leases with the lease term of 12 months or less with no purchase option (applied to the whole class of assets)
- Leases where underlying asset has a low value when new (applied on one-by-one basis)
If you apply this exemption, you don’t have to calculate the lease liability and right-of-use asset.
Instead, you can recognize the lease payments straight in profit or loss.
I am mentioning it here because you have the option to apply these exemptions on transition to IFRS 16.
However, if you apply this exemption on transition, you need to be consistent and apply it also for all new similar leases – especially the short-term lease exemption, because it has to apply for the whole class of assets.
When it comes to exemption related to low value assets, you can apply it lease by lease, but you still need to define in your policies how you assess the low value assets.
Decision #3: Full or modified retrospective approach?
I have dedicated the full article with illustrative examples to explanation of these 2 different approaches, so check it out here.
Let me just add one quite significant point when it comes to measuring lease liability under full retrospective approach vs. modified retrospective approach.
What discount rates shall you use for measuring your lease liability?
- If you apply full retrospective approach, you need to use the discount rate applicable at the lease commencement date.
- If you apply modified retrospective approach, you need to use the discount rate applicable at the date of initial application, not at the commencement date.
If these two rates are different, it could also have the strong impact on your equity.
Let’s make some comparison.
Let’s take the same example as solved here and use different discount rates when using full and modified approaches.
Just to refresh your memory, here are the basic facts of the example:
- ABC needs to make adjustment related to operating lease contract
- Inception date: 1 January 2017
- Lease term: 5 years
- Annual rental payments: CU 100 000 on 31 December each year
- Machine’s economic life: 10 years
- Machine will be returned back to the lessor after the lease term.
- Mandatory effective date: 1 January 2019
Let’s say that the discount rates are as follows:
- At the commencement date (1 January 2017): 3%
- At the date of initial application of IFRS 16 when using modified approach (1 January 2019): 2.5%
Lease liability under the full retrospective approach
Under full retrospective approach, the lease liability at 1 January 2019 is measured as if IFRS 16 has always been in place; using the discount rate of 3%.
Let me remind you the calculation we made:
As you can see, the lease liability at 1 January 2019 (or at the end of 2018) under full retrospective approach is CU 282 861.
Lease liability under the modified retrospective approach
Upon transition to IFRS 16 and using modified retrospective approach, ABC will measure the lease liability as the present value of the lease payments not paid at the date of adjustment, discounted using the discount rate applicable at the date of initial application (here 2.5%).
Thus, at 1 January 2019, three payments are not paid and their total present value is calculated using the following formula:
In this case, it is CU 100 000 x ((1-(1,025^-3))/0.025) = CU 285 602.
As you can see, due to decline in a discount rate, the lease liability at 1 January 2019 is greater under modified approach than under full approach.
That’s the price of making things easier and applying modified approach.
However, if the interest rates increase over time, then modified approach would trigger the opposite effect.
But, that’s your job to analyze.
Decision #4: How to apply modified retrospective approach?
It seems that the modified retrospective approach to IFRS 16 transition is more popular than the full approach.
Although the full approach provides more comparable information, it is a way cheaper and easier to apply IFRS 16 using modified approach, despite the fact that it can produce different impact on equity.
In my illustrative example solved here I selected one way of applying modified approach just to show the difference between the full and modified version.
However, a few practical expedients are available when you use modified approach and thus it is possible that two companies with the same leases will get different results under modified approach based on their choices.
One of the most significant choices is selecting HOW you will measure the right-of-use asset.
Under full approach it is clear and the only choice is as IFRS 16 has always been in place.
How about modified approach?
Measurement of right-of-use asset at the transition date (modified approach)
You has 2 options here:
- Option 1: As IFRS 16 has always been applied (using discount rate at the date of adjustment) – for our example, see calculation below.
- Option 2: In the amount of a lease liability: CU 285 602 – see calculation above (Decision #3)
Let me measure ROU asset as if IFRS 16 has always been applied, just using discount rate at the date of initial application.
In this simple example, there were no initial direct costs related to the lease or other items, so ROU asset at the commencement date would be equal to the lease liability at the commencement date.
Therefore we need to discount all lease payments with the discount rate of 2.5% (applicable at the date of initial application of IFRS 16).
The formula is similar as above, we just need to use the full lease term of 5 years:
CU 100 000 x ((1-(1,025^-5))/0.025) = CU 464 583.
This is the ROU asset at the commencement date of 1 January 2017 and we still need to deduct the depreciation charge for 2 years to bring it to 1 January 2019.
Let’s charge the straight-line depreciation over 5 years, thus the carrying amount of ROU asset at 1 January 2019 is: CU 464 583 – 464 583/5*2 = CU 278 750.
And, that is a difference of CU 6 852 when compared to using option 1.
Comparing three methods of transition to IFRS 16
To show you the journal entry and impact on equity of this exercise under different methods, I summed it up in the following table:
|Journal entry at 1 Jan 2019||Full retrospective||Modified – Option 1||Modified – Option 2|
|Debit ROU asset||274 783||278 750||285 602|
|Credit Lease Liability||-282 861||-285 602||-285 602|
|Debit Equity||8 078||6 852||0|
Note – amounts for full retrospective come from the example solved here.
Now you see the difference.
If you implement IFRS 16 using modified approach and you opt for practical expedient related to measuring your ROU asset, you will have probably the smallest impact on equity (in this example none).
Just a small note: you can opt this practical expedient on lease-by-lease basis, thus you can apply it selectively for some leases (no necessity to apply for all of them).
Decision #5 for modified approach: other practical expedients
To ease your life, IFRS 16 gives you the option to go for another practical expedients that can potential make the transition less challenging.
Let me name a few of them:
- Discount rates
You may apply a single discount rate to a whole portfolio of leases with reasonably similar characteristics.
- Onerous contracts
If you assessed the lease as onerous contract under IAS 37 immediately before the date of initial application, you do NOT have to perform the impairment test on right-of-use asset, but you can adjust its carrying amount by the amount of provision for onerous contract instead.
- Leases with remaining term of less than 12 months
If the lease term of some lease contract ends within 12 months after the date of initial application, you can account for it as for short-term lease (i.e. all lease payments in profit or loss).
- Initial direct costs
You can exclude initial direct costs from the measurement of right-of-use asset at the date of initial application.
You can use hindsight in determining the lease term if the contract contains option to extend or to terminate the lease.
In other words – you can assess this option based on the previous experience.
Oh, I almost forgot – the mysterious shortcut “CU” means “currency unit” – it replaces any currency for the purpose of examples. Just because many of you are asking me this.
Please, have you already adopted IFRS 16? Or are you just in the process?
Let me know in the comments how it went and what challenges you faced. Thank you!
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