Leases (IFRS 16)
Liabilities
Leases (IFRS 16)
Syllabus tag: KASNEB CPA | Intermediate Level | CA23 Financial Reporting and Analysis | Topic 5 Leases
Lesson objectives
By the end of this topic, you will be able to:
- Explain why IFRS 16 removed the operating lease from lessee accounting
- Measure a lease liability and a right-of-use asset at inception
- Prepare a lease liability amortisation table
- Split the liability between current and non-current
- Apply the two recognition exemptions
Why this matters
Before IFRS 16, a company could rent a fleet of aircraft for twenty years and show neither the aircraft nor the obligation on its balance sheet. Two airlines with identical operations looked completely different depending on how they worded their contracts. IFRS 16 ended that.
The single lessee model
A lessee now recognises, for almost every lease:
- a right-of-use asset, because it controls the use of the asset
- a lease liability, because it must make the payments
The old operating and finance lease distinction survives only for lessors. For lessees there is one model.
Initial measurement
Lease liability = present value of the lease payments, discounted at the rate implicit in the lease, or the lessee's incremental borrowing rate where that is not readily determinable.
Right-of-use asset = the liability, plus any payments made at or before commencement, plus initial direct costs, plus estimated restoration costs, less any lease incentives received.
One lease throughout
Chui Ltd leases equipment for 5 years. The lease liability at commencement is KES 10,000,000, the interest rate 8%, and the annual payment KES 2,504,565 in arrears.
Right-of-use asset = KES 10,000,000, depreciated over 5 years = KES 2,000,000 a year.
Note the asset is depreciated over the lease term, not the asset's useful life, unless ownership transfers at the end.
The amortisation table
| Year | Opening | Interest at 8% | Payment | Reduction | Closing |
|---|---|---|---|---|---|
| 1 | 10,000,000 | 800,000 | 2,504,565 | 1,704,565 | 8,295,435 |
| 2 | 8,295,435 | 663,635 | 2,504,565 | 1,840,930 | 6,454,506 |
| 3 | 6,454,506 | 516,360 | 2,504,565 | 1,988,204 | 4,466,302 |
| 4 | 4,466,302 | 357,304 | 2,504,565 | 2,147,260 | 2,319,041 |
| 5 | 2,319,041 | 185,523 | 2,504,565 | 2,319,041 | nil |
The liability amortises to exactly nil, which is the check that the working is right.
Notice the pattern: interest falls and the capital reduction rises each year, because interest is charged on a shrinking balance. Payments in arrears attract a full year of interest before the first payment; payments in advance reduce the liability immediately, so no interest arises in year one.
Splitting current from non-current
At the end of year 1 the liability is KES 8,295,435. The split is:
- Current = the capital repaid in year 2 = KES 1,840,930
- Non-current = 8,295,435 − 1,840,930 = KES 6,454,506
The current portion is the capital element of next year's payment, not the whole payment. Using 2,504,565 includes interest that has not yet accrued and is a common error.
The effect on the financial statements
Compare the two treatments over the lease:
| Old operating lease | IFRS 16 | |
|---|---|---|
| Balance sheet | nothing | asset and liability |
| Income statement | rental expense, level | depreciation plus interest |
| Profile of charge | flat | front-loaded |
Depreciation is level at 2,000,000, but interest is 800,000 in year 1 and 185,523 in year 5. Total charge falls from 2,800,000 to 2,185,523 across the lease, while the total over the whole term is the same as the total rentals.
Two consequences that matter to analysts: gearing rises, because a liability appears that was previously invisible; and EBITDA improves, because a rental expense that sat above the line has become depreciation and interest, which sit below it. Neither reflects any change in the business.
:::checkpoint A company's gearing ratio worsened sharply in the year it adopted IFRS 16, though it signed no new agreements and its operations were unchanged. Explain to a shareholder what happened and whether the company is riskier than before. :::
The two exemptions
A lessee may choose not to apply the model to:
- Short-term leases of 12 months or less
- Low-value assets — laptops, office furniture, small equipment, judged on the value when new rather than to the lessee
For these, the payments are recognised as an expense on a straight-line basis, which is the old operating lease treatment.
The exemptions exist for practicality. Recognising a right-of-use asset for every office chair would cost far more than the information is worth.
:::checkpoint A company leases 400 laptops on three-year contracts and one building on a fifteen-year lease. Say which exemption, if any, applies to each and give your reasoning. :::