What is the New Standard of IFRS 18?
The International Financial Reporting Standards (IFRS) is a globally recognized set of accounting standards, which provide guidelines for companies to follow when preparing financial statements. It is an essential part of maintaining transparency and consistency in financial reporting across borders. One of the most important standards within the IFRS framework is IFRS 18, which governs accounting for leases. However, it’s important to note that IFRS 18 itself has been superseded by IFRS 16, which took effect starting in 2019.
While the standard has evolved, the legacy of IFRS 18 still influences accounting practices today. This tutorial will explore the changes brought by IFRS 18 and its successor IFRS 16. We will go through the concept of leases, its treatment under IFRS 18, the journal entries involved, and the preparation of financial statements.
Overview of IFRS 18 and its Successor, IFRS 16
In the past, IFRS 18 provided guidelines for revenue recognition for leases and other contracts, focusing largely on how leases were recognized and measured. Under IFRS 18, leases were generally classified into two types:
- Finance Leases: Where the risks and rewards of ownership were transferred to the lessee.
- Operating Leases: Where the lessor retained the risks and rewards of ownership.
The shift from IFRS 18 to IFRS 16 aimed to improve lease accounting by requiring lessees to recognize nearly all leases on the balance sheet. IFRS 16 has significantly changed the way leases are reported, especially by lessees.
Key Changes in IFRS 16
The most notable difference between IFRS 18 and IFRS 16 is the treatment of operating leases. Under IFRS 18, operating leases were not recognized on the balance sheet; instead, only rental payments were recorded in the income statement. However, IFRS 16 requires that all leases, whether operating or finance, be recorded on the balance sheet. This change aims to increase transparency and comparability for users of financial statements.
The main principles of IFRS 16 are:
- Lessee Accounting: Lessees are required to recognize a right-of-use (ROU) asset and a lease liability for most leases. The ROU asset represents the lessee’s right to use the leased asset during the lease term, and the lease liability represents the obligation to make lease payments.
- Lessor Accounting: The accounting for lessors remains largely the same under IFRS 16. They continue to classify leases as finance or operating leases and account for them accordingly.
Journal Entries Under IFRS 16
Understanding the journal entries involved in IFRS 16 is crucial for preparing accurate financial statements. Let’s go through the journal entries a lessee would make under IFRS 16, including the initial recognition and subsequent measurement.
Initial Recognition of Lease
At the commencement of the lease, the lessee will recognize a lease liability and a corresponding right-of-use (ROU) asset. The lease liability is initially measured at the present value of future lease payments, discounted using the lessee’s incremental borrowing rate or the interest rate implicit in the lease.
- Journal Entry:
- Debit: Right-of-Use Asset
- Credit: Lease Liability
For example, if a company enters into a lease agreement for a piece of equipment with a total future lease obligation of $100,000, the initial entry would be:
| Date | Account | Debit | Credit |
|---|---|---|---|
| 01/01/2024 | Right-of-Use Asset | 100,000 | |
| 01/01/2024 | Lease Liability | 100,000 |
Lease Payments
Each lease payment made by the lessee consists of both an interest portion and a principal portion. The interest portion is calculated based on the outstanding lease liability, while the principal portion reduces the lease liability.
- Journal Entry (for each lease payment):
- Debit: Lease Liability (for principal portion)
- Debit: Interest Expense (for interest portion)
- Credit: Cash
Let’s assume that the total lease payment is $20,000, and $5,000 is attributed to interest while the remaining $15,000 is applied toward the principal.
| Date | Account | Debit | Credit |
|---|---|---|---|
| 01/02/2024 | Lease Liability | 15,000 | |
| 01/02/2024 | Interest Expense | 5,000 | |
| 01/02/2024 | Cash | 20,000 |
Depreciation of Right-of-Use Asset
Since the lessee has the right to use the asset over the lease term, the ROU asset will be depreciated. The depreciation expense is typically recognized on a straight-line basis over the lease term unless another method is more appropriate.
- Journal Entry (for depreciation):
- Debit: Depreciation Expense
- Credit: Accumulated Depreciation (Right-of-Use Asset)
For example, if the lease term is 5 years, and the ROU asset is being depreciated on a straight-line basis, the annual depreciation would be:
| Date | Account | Debit | Credit |
|---|---|---|---|
| 01/01/2024 | Depreciation Expense | 20,000 | |
| 01/01/2024 | Accumulated Depreciation | 20,000 |
End of Lease Term or Lease Modifications
At the end of the lease term, the lessee will either return the leased asset or purchase it if the lease includes a buyout option. If the lease is modified (e.g., an extension is agreed), the lease liability will be recalculated based on the revised terms.
- Journal Entry (for lease modification):
- Debit: Lease Liability
- Credit: Right-of-Use Asset
For a lease modification, the lessee recalculates the lease liability based on the revised payment schedule, adjusting the ROU asset accordingly.
Lessee’s Financial Statements under IFRS 16
The financial statements of a lessee under IFRS 16 will include both the ROU asset and the lease liability on the balance sheet, which were not required under the previous standard, IFRS 18. Below is an example of how these changes might be reflected in the balance sheet and income statement.
Example Balance Sheet under IFRS 16
| Assets | Liabilities & Equity | ||
|---|---|---|---|
| Right-of-Use Asset | 100,000 | Lease Liability | 100,000 |
| Cash | 50,000 | ||
| Total Assets | 150,000 | Total Liabilities | 100,000 |
| Equity | 50,000 |
Example Income Statement under IFRS 16
| Revenue | |||
|---|---|---|---|
| Sales | 500,000 | ||
| Expenses | |||
| Depreciation Expense | 20,000 | ||
| Interest Expense | 5,000 | ||
| Total Expenses | 25,000 | ||
| Net Income | 475,000 |
Lessor’s Accounting under IFRS 16
Although the major changes under IFRS 16 primarily affect lessees, lessors are still required to classify leases as either operating or finance leases. The accounting for lessors under IFRS 16 is similar to the approach under IFRS 18, with a few modifications in disclosure.
For finance leases, lessors continue to recognize the leased asset as a receivable, measuring it at the present value of lease payments. For operating leases, lessors continue to recognize rental income over the lease term.
Lessor’s Journal Entries (Finance Lease)
At the commencement of the lease:
| Date | Account | Debit | Credit |
|---|---|---|---|
| 01/01/2024 | Lease Receivable | 100,000 | |
| 01/01/2024 | Leased Asset | 100,000 |
For each lease payment:
| Date | Account | Debit | Credit |
|---|---|---|---|
| 01/02/2024 | Cash | 20,000 | |
| 01/02/2024 | Lease Receivable | 15,000 | |
| 01/02/2024 | Interest Income | 5,000 |
Conclusion
The shift from IFRS 18 to IFRS 16 brought significant changes in the way leases are accounted for, with the most important change being the requirement for lessees to recognize both a right-of-use asset and a lease liability on their balance sheets. The journal entries and the subsequent measurement of these assets and liabilities affect the financial statements in a variety of ways, including the income statement and balance sheet.
These changes improve transparency in financial reporting and provide a clearer picture of an entity’s financial position, particularly for companies with large lease obligations. Although IFRS 16 has replaced IFRS 18, understanding the legacy of IFRS 18 is still valuable in grasping the evolution of lease accounting and the broader implications for financial reporting.