Accounting for leases – 2019 update

This blog is relevant for those businesses preparing their accounts under International Financial Reporting Standards. Whilst the following does not apply to those businesses using UK accounting standards (e.g. Financial Reporting Standard 102), one wonders if the direction of travel will eventually make new rule applicable for all UK entities in due course?

IFRS 16 is the new standard for lease accounting which came into force in January 2019. It replaced the old IAS 17 lease accounting standard. Basically, the changes apply to the way to account for lease agreements that companies take out on property, plant and equipment.

The objective of the changes is to make sure that all companies return information for leased assets in the same way, making their existence more transparent financially. Previously, businesses could hold large financial liabilities on their operating leases but keep them off their balance sheet, giving a skewed view of their overall financial status.

Previously under IAS 17, leases were split in to either operating leases and finance leases, whereby operating leases were kept off the balance sheet and charges were simply included within the profit or loss account.

The biggest change is that under the new standard, most leased items will now have to be included as a ‘right of use’ asset and a corresponding liability will have to be recognised, similar to the old finance lease treatment.

The asset and liability should initially measured at the present value of lease payments over the lease term discounted at the rate implicit of the lease. For example, if a company were to enter a contract where they leased a crane for 3 years. The total contract price is £180,000 and the interest rate is 5%.

Initially a present value will need to be calculated to recognise the ‘right of use’ asset and liability.

Year Cash flow (£) Discount rate (5%) Present value (£)
1 60,000 1/1.05 57,143
2 60,000 1/1.052 54,054
3 60,000 1/1.053 51,724
162,921

 

Subsequently, the asset should be treated as and depreciated (or revalued) consistently with other assets within the same class, with the relevant expense being reported to the profit or loss account.

The lease liability should be paid off similar to a normal finance lease, where a payment will reduce the lease liability and interest will increase the liability. The interest being charged on the lease will decrease each year in line with the decrease in the lease liability.

A complication to this standard is that additional costs such as maintenance or cleaning must be separated out from the main lease payments and reported separately (if they are included within the lease payment).

Exceptions to the rule

There are two specific types of lease which do not have to be included as an asset on the balance sheet under these new rules:

  1. A lease with a shorter than 12 month term which does not have an option to buy the leased asset at the end of the lease.

For example, if a vehicle was leased with a period less than 12 months and there is no option to buy the vehicle at the end of the contract, then the vehicle does not have to be included as an asset on the balance sheet.

  1. The underlying asset has a low value such as a PC or small item of office furniture (the standard currently has this set at US$5,000).

 

Blog written by Michael Chapman

 

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