IFRS 16 came into force to replace IAS 17 with the aim of specifying how lessees and lessors should recognize, measure, present, and disclose leases. It ensures that financial statements reflect a true and fair view of an entity’s leasing activities.
Importance of IFRS 16.
- It improves comparability as a consistent set of rules is applied to the financial statements regardless of industry and geographical location.
- It enhances transparency as a clear reporting framework for disclosure of leasing activities has been provided.
A lease is defined as an agreement where one party (the lessee) obtains the right to use an asset for a specific timeframe in exchange for agreed-upon payments to the other party (the lessor).
At the start of a lease, a lessee will recognize the following:
- Right-of-use (RoU) asset representing its right to use the underlying leased asset throughout the lease term, and
- Lease liability representing its obligation to make lease payments.
Right of Use Asset
The RoU asset is initially measured at cost, primarily comprising of an amount equivalent to the recognised lease liability, and any initial indirect costs. It includes:
- An amount equivalent to the Lease Liability on initial recognition,
- Lease payments made on or before the lease’s commencement date, less any lease incentives received,
- Any initial indirect cost incurred by the lessee; and
- An estimate of costs expected to be incurred by the lessee for dismantling and removing the underlying asset, restoring the site where it is located or restoring the underlying asset to the condition stipulated by the lease terms and conditions, excluding those costs related to producing inventories.
The subsequent measurement involves applying depreciation and assessing impairment charges.
Lease Liability
The lease liability is initially measured at the present value of lease payments and includes:
- Fixed payments, less any lease incentives receivable,
- Variable lease payments that depend on an index or a rate,
- Amounts the lessee expects to pay under residual value guarantees,
- Exercise price of a purchase option if the lessee is reasonably certain to exercise that option; and
- Penalty payments for lease termination if the lease term reflects the lessee’s choice to terminate the lease
The value of the lease liability changes over time due to the accrual of interest, the regular lease payments made, and adjustments made to account for any changes to the lease agreement. Therefore, lease payments reduce the carrying amount of the lease liability.
Interest and Depreciation.
Lessees will incur interest on the lease liability and depreciation on the right-of-use asset, impacting their income statement.
IFRS 16 significantly impacts how leases are accounted for. By recognizing both a right-of-use asset and a lease liability, companies provide a more complete picture of their leasing activities and their financial position. While the initial implementation of IFRS 16 may have presented challenges, it ultimately aims to enhance financial reporting quality and improve decision-making for investors, creditors, and other stakeholders.
This material is intended solely for informational purposes and should not be relied upon without seeking specific professional advice on the matter. Should you have any questions regarding this topic, please feel free to contact our team at info@ke.andersen.com or +254 20 5100263.
Contributors & Contact Persons
Ruth Kwamboka
Tax Associate
ruth.kwamboka@ke.andersen.com
Marco Manyenze
Associate Director
marco.manyenze@ke.andersen.com