Leases capitalisation on the balance sheet

Summary Leases capitalisation on the balance sheet

IFRS 16 includes a single accounting model for all leases by lessees.

The main implications of the new standard on current practice for lessees include:

  • Operating leases are similar (but differently) to finance leases recorded in the financial position under IFRS 16 (subject to the exceptions described below)
  • All leases (subject to the exceptions described below) will be capitalised on the balance sheet by recognising a ‘right-of-use’ asset and a lease liability for the present value of the obligation
  • No rental expense! i.e. no more straight-line expenses for operating lease costs. All leases will incur a front-end loaded expense, comprising depreciation on the right-of-use asset, and interest on the lease liability
  • When initially measuring the right-of-use asset and a lease liability, non-cancellable lease payments (including inflation-linked payments), as well as payments for option periods which the entity is reasonably certain to exercise, must be included in the present value calculation.

Lessees of retail premises paying contingent (turnover) rentals, and others required to make significant contingent rental payments, will be relieved to know that these will not be capitalised into the right-of-use asset, but will continue to be expensed in profit or loss.

Recording of Leases capitalisation on the balance sheet

The capitalized lease method is an accounting approach that posts a company’s lease obligation as an asset on the balance sheet. If the lease agreement meets at least one of the two criteria provided in IFRS 6 Leases, the lease is capitalized, which means that the lessee (the company leasing the asset from another) recognizes both depreciation expense (in operating profit) and interest expense (in profit before tax) on the lease, instead of lease expenses (in operating profit only).

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The lessee also posts a lease obligation in the liability section of the balance sheet for the same dollar amount as the asset. Over time, the leased asset is depreciated and the carrying value declines.

Lease recognition criteria

At inception of a contract, an entity shall assess whether the contract is, or contains, a lease. A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Paragraphs B9–B31 set out guidance on the assessment of whether a contract is, or contains, a lease. The two major criteria in IFRS 16 B9 are:

IFRS B9 To assess whether a contract conveys the right to control the use of an identified asset (see paragraphs B13–B20) for a period of time, an entity shall assess whether, throughout the period of use, the customer has both of the following:

  1. the right to obtain substantially all of the economic benefits from use of the identified asset (as described in paragraphs B21–B23); and
  2. the right to direct the use of the identified asset (as described in paragraphs B24–B30).
A lessee must capitalize a leased asset if the lease contract entered into satisfies at least one of the four criteria published by the Financial Accounting Standards Board (FASB). An asset should be capitalized if:

Industries and assets most impacted Leases capitalisation on the balance sheet

Leases capitalisation on the balance sheetIFRS 16 will result in higher debt levels and interest costs (particularly in the earlier years of a lease) for any entities operating in industries that currently have many operating leases of high value that are material to their balance sheets. For example:

  • Retailers – their shops or mall space, particularly where leases include multiple renewal options (e.g. anchor tenants in a shopping mall),
  • Mines and mining services companies, where there is a significant amount of expensive equipment held on operating leases,
  • Airlines – millions, and in some cases, billions of dollars will be required to be capitalised on balance sheet for aircraft,
  • Cruise ship operators – as for airlines above,
  • Businesses with large fleets of motor vehicles, including cars and trucks.
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Exceptions Leases capitalisation on the balance sheet

Lessees can choose not to apply the IFRS 16 requirements to the following types of leases:

  • Short-term leases – leases for a period of 12 months or less from commencement date, including any extension options,
  • ‘Small ticket’ or low value items – items which, when new, have a low value, e.g. laptops, tablets, computers, small items of furniture and equipment.

This low value item is applied to an item, not to a group of items, and applies to the ‘as new’ value, not a second hand value, meaning that vehicles are unlikely to meet the requirements for a small ticket item.

Lease payments for these assets will be recognised on a straight line basis over the lease term, or another systematic basis if more representative of the pattern of the lessee’s benefits.

No change to current practice – lessors Leases capitalisation on the balance sheet

There have been no changes in the requirements for accounting by lessors required by IAS 17 Leases (the old standard). This means that the distinction between operating and finance lease assets will remain.

Effective date Leases capitalisation on the balance sheet

IFRS 16 is operative for annual periods beginning on or after 1 January 2019 and can be adopted early if IFRS 15 Revenue from Contracts with Customers is adopted for the same accounting period.

Leases capitalisation on the balance sheet

Leases capitalisation on the balance sheet

Leases capitalisation on the balance sheet Leases capitalisation on the balance sheet Leases capitalisation on the balance sheet

Leases capitalisation on the balance sheet Leases capitalisation on the balance sheet Leases capitalisation on the balance sheet

Leases capitalisation on the balance sheet Leases capitalisation on the balance sheet Leases capitalisation on the balance sheet

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