Lease Obligations Under IFRS 16 - A Step-by-Step Guide
16 Dec 2023
14 min read
Companies generally use leasing arrangements as a means of obtaining assets. Consequently, IFRS 16 requires the majority of leased assets and the associated obligations to be recognised in the financial statements. This is a significant change from the previous standard, IAS 17 Leases, which was criticised for allowing 'off balance sheet' financing.
While IFRS 16 has benefits for the users of financial statements in terms of transparency and comparability, it has had a significant impact on the most commonly used financial ratios, such as:
• Gearing, because debt has increased
• Asset turnover, because assets have increased
• Profit margin ratios, because rent expenses are removed and replaced with depreciation and finance costs.
This in turn affects the way in which users interpret and analyse the financial statements. For example, banks often impose loan covenants when making loans to companies. These covenants may need renegotiating if applying IFRS 16 causes a company's liabilities to increase significantly.
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Accounting for the Lease Liability under IFRS 16 Leases
Initial Measurement of Lease Liability (IFRS 16)
The lease liability is initially measured at the present value of lease payments not paid at the commencement date, discounted at the interest rate implicit in the lease (or the lessee's incremental borrowing rate if not readily determinable)
In this case, the borrowing rate is the rate to borrow over a similar term, with similar security, to obtain an asset of similar value in a similar economic environment.
The lease liability cash flows to be discounted include the following;
Fixed payments
Variable payments that depend on an index (e.g. CPI) or rate (e.g. market rent)
Amounts expected to be payable under residual value guarantees (e.g. where a lessee guarantees to the lessor that an asset will be worth a specified amount at the end of the lease)
Purchase options (if reasonably certain to be exercised).
Other variable payments (e.g. payments that arise due to level of use of the asset) are accounted for as period costs in profit or loss as incurred.
Subsequent Measurement of Lease Liability (IFRS 16)
The lease liability is subsequently measured by;
Increasing it by interest on the lease liability
Reducing it by lease payments made.
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Activity Question
A company enters into a 4-year lease commencing on 1 January 2023 (and intends to use the asset for 4 years). The terms are 4 payments of UGX50 million, commencing on 1 January 2023, and annually thereafter. The interest rate implicit in the lease is 7.5% and the present value of lease payments not paid at 1 January 2023 (i.e. 3 payments of UGX50 million) discounted 'at that rate is UGX130,026,000.
Legal costs to set up the lease incurred by the company were UGX402,000.
Required
Show the lease liability from 1 January 2023 to 31 December 2026
SOLUTION
About the Writer
CPA Innocent MUGISHA
CPA Innocent Mugisha is a Professor of Finance and Accounting with over 10 years experience in teaching Accounting and Finance related courses including Financial Accounting both at University and Professional level. His qualifications are: PhD (candidate), MBA(Finance), CPA(U), FCCA, CIPS, CTA and BCOM (Accounting). Innocent has also published various books on most topics in Accounting and Finance for Business and Professional Studies.
