How to Implement IFRS 16 Under Finance Lease: A Practical Guide

My introduction

Hi, my name is Ihtasham Shafique, and I am a qualified member of the professional accountancy body ICMAP, holding the ACMA designation. Today, I will be providing a detailed guide on the practical implementation of IFRS 16 for finance leases. This comprehensive overview is designed to assist you in applying these principles effectively in your professional endeavors.

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Understanding IFRS 16

Implementing IFRS 16 can be complex, but it's crucial for accurate financial reporting. This article provides a clear, step-by-step guide to implementing IFRS 16 for finance leases, complete with a practical example. IFRS 16 requires companies to recognize leases on the balance sheet, providing greater transparency. A finance lease transfers substantially all risks and rewards of ownership to the lessee, unlike an operating lease.

Identifying Finance Leases

?A lease is classified as a finance lease if it meets certain criteria, such as transferring ownership, having a purchase option, or the lease term covering the major part of the asset's economic life.

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Example:

Company ABC enters into a 5-year lease for Truck. Annual lease payments are $50,000, payable at the end of each year. The company's incremental borrowing rate is 5%.

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Key Data:

• Lease term: 5 years
• Annual payments: $50,000
• Incremental borrowing rate: 5%

Initial Measurement

• Lease Liability: Calculate the present value of lease payments.

????? Present value of lease payments using the incremental borrowing rate:

Lease?Liability=50,000×(1?(1+0.05)^-5/0.05)=50,000×4.32948=216,474

• ·Right-of-Use Asset: The?fair?value?(or,?if?lower,?the?present?value?of?the?MLPs)?should?be? included?as?a?noncurrent?asset,?subject?to?depreciation

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Which accounts needed to open in your financial software.

In your ERP software, you will need to set up an asset account for the right-of-use asset, which will be subject to depreciation, and a liability account under long-term liabilities to record the lease liability. Here's how you can do this:

·? Create the Asset Account:

• Account Name: Right-of-Use Asset - Truck
• Account Type: Fixed Asset (under Equipment)
• Depreciation: Enable depreciation for this account, typically using a method such as straight-line over the lease term or the useful life of the truck which ever is lower.

·? Create the Liability Account:

• Account Name: Lease Liability - Truck
• Account Type: Long-Term Liability

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Journal Entries at Commencement Date:

• Debit Right-of-Use Asset - Truck: $216,474
• Credit Lease Liability - Truck: $216,474

Subsequent Measurement:

• Interest Expense (Year 1): $216,474 * 5% = $10,824
• Lease Payment (Year 1): $50,000
• Lease Liability Reduction (Year 1): $50,000 - $10,824 = $39,176

Journal Entry (End of Year 1):

• Debit Interest Expense: $10,824
• Debit Lease Liability - Truck: $39,176
• Credit Cash: $50,000
• Depreciation Expense (Year 1): $216,474 / 5 = $43,295
• Journal Entry (End of Year 1):

·??????? Debit Depreciation Expense: $43,295

·??????? Credit Accumulated Depreciation - Right-of-Use Asset - Truck: $43,295

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This outlines the entire accounting process for Year 1, detailing how amounts are recorded in the profit and loss account and the balance sheet. It’s important to note that all accounting entries should be made on a monthly basis; therefore, please adjust these annual amounts to reflect the monthly figures accordingly.

For the benefit of readers, I am sharing the comprehensive lease table, which includes detailed calculations over the five-year period.

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Detailed Calculations: These calculations will help you to understand the table

1. Year 1: Interest Expense: $216,474 * 5% = $10,824 Principal Repayment: $50,000 - $10,824 = $39,176 Closing Lease Liability: $216,474 - $39,176 = $177,298 Depreciation Expense: $216,474 / 5 = $43,295
2. Year 2: Interest Expense: $177,298 * 5% = $8,865 Principal Repayment: $50,000 - $8,865 = $41,135 Closing Lease Liability: $177,298 - $41,135 = $136,163 Depreciation Expense: $216,474 / 5 = $43,295
3. Year 3: Interest Expense: $136,163 * 5% = $6,808 Principal Repayment: $50,000 - $6,808 = $43,192 Closing Lease Liability: $136,163 - $43,192 = $92,971 Depreciation Expense: $216,474 / 5 = $43,295
4. Year 4: Interest Expense: $92,971 * 5% = $4,649 Principal Repayment: $50,000 - $4,649 = $45,351 Closing Lease Liability: $92,971 - $45,351 = $47,620 Depreciation Expense: $216,474 / 5 = $43,295
5. Year 5: Interest Expense: $47,620 * 5% = $2,381 Principal Repayment: $50,000 - $2,381 = $47,620 Closing Lease Liability: $47,620 - $47,620 = $0 Depreciation Expense: $216,474 / 5 = $43,295

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