AASB 16 Leases: Your Questions Answered (With Examples)
Accounting Standard AASB 16 Leases was introduced in 2018. Although it is no longer new, many entities continue to grapple with the challenges of this accounting standard. In this article, we aim to provide some guidance around this standard and how it may apply to your business.
Background
Most organisations in Australia undertake some form of leasing activity whether it is renting a corporate office or equipment such as photocopiers, laptops or vehicles.
Prior to AASB 16 coming into effect in 2019, lease arrangements were classified as operating leases – which resulted in expenses being recorded on a systematic basis over the life of the lease through the income statement, with no impact to the balance sheet (statement of financial position).
AASB 16 changed this accounting. It requires the majority of leases held by lessees to be recorded on the balance sheet.
Lessor accounting was left substantially unchanged with the introduction of AASB 16, and lessors continue to classify their leases as operating or finance. Therefore, lessor accounting will not be discussed in this article.
Why did the classifications change?
The previous classification of leases as operating leases meant that many entities with significant assets that were critical to their business were not recording them in their financial statements. The liabilities associated with the leases were also understated.
In addition, users of the financial statements, such as analysts and banks, were adjusting the financial statements for the previous operating lease commitments note in making their decisions and these adjustments were inconsistent and often not correct.
How are leases now recorded in the financial statements?
Fundamentally, all leases in place for any entity (i.e. any agreements meeting the definition of a lease (see below)) will be recorded in the balance sheet as a non-current right of use asset with an associated lease liability (separated into current and non-current components).
The income statement (statement of profit or loss and other comprehensive income) will show the lease expense split between straight line depreciation of the right of use asset, and interest relating to the lease liability.
Rent expense is not disclosed as an operating expense.
What agreements will meet the definition of a lease?
A lease is defined in AASB 16 as ‘a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration’.
To ensure all leases have been identified, an entity is required to consider all agreements which involve the use of an asset to determine whether it contains an embedded lease regardless of the name of the agreement – this might include agreements such as supply agreements, usage agreements, management agreements, outsourcing agreements.
Exceptions from lease accounting
Once the population of leases has been identified, there are two exceptions to lease accounting which lessees can choose to apply – short term leases and leases of low value assets.
| EXCEPTIONS | ||
|---|---|---|
| Short-term leases | Lease term is less than or equal to 12 months. Lease does not include a purchase option (any lease with a purchase option is not able to be classified as short-term). Note: if the short-term lease is continuously rolled over, then it is no longer short-term. | |
| Low value assets | Value of the underlying asset (when new) is low value Includes items such as laptops, most office furniture Excludes vehicles | |
If either of these options are able to be used and the entity chooses to apply the exception, then the lease payments associated with those leases are recognised as an expense on either a straight-line basis over the lease term or another systematic basis.
How does lease accounting work under AASB 16?
| Key points for the balance sheet | ||
|---|---|---|
| Right of use asset | Lease Liability | |
| Presentation | Non-current asset which follows treatment of the underlying assets. May be presented separately on the face of the balance sheet or as additional classes within the IPPE note. | Current and non-current lease liability over the lease term |
| Calculation | Lease Liabililty + Initial direct costs + Prepaid lease payments + Restoration costs + lease incentives | Present value of cash flow over the lease term Discount rate is rate implicit in the lease OR If not readily determinable then the entity’s incremental borrowing rate |
Example of application
| Lessee Limited leases a vehicle under the following terms | |
|---|---|
| Length of lease | 5 years |
| Commencement date | 1 January 2024 |
| Lease payments | $500 per month |
| Initial direct costs to take out the lease – legal fees | $ 525 |
| Entities’ incremental borrowing rate | 6% |
| Previous accounting under the old accounting standard (1) | ||||||
|---|---|---|---|---|---|---|
| 2024 ($) | 2025 ($) | 2026 ($) | 2027 ($) | 2028 ($) | Total ($) | |
| Income statement | ||||||
| Operating expense – rent | -6000 | -6000 | -6000 | -6000 | -6000 | -30000 |
| Legal fees | -525 | 0 | 0 | 0 | 0 | -525 |
| Profit or loss impact | -6525 | -6000 | -6000 | -6000 | -6000 | -30525 |
| Balance sheet | ||||||
| Right of use asset | – | – | – | – | – | – |
| Lease liability | – | – | – | – | – | – |
| (1) Note: if an entity chooses to apply short-term lease or lease of low-value asset exception then this accounting continues to be used for those leases. This is not relevant for this example since the lease is not short-term and the asset is not low value. | ||||||
Accounting under AASB 16
On day 1 the lessee will record a lease liability of $25,274 (which is the discounted future cash flows), a right of use asset of $25,799 (being the lease liability plus the initial direct costs) and a cash payment for legal fees of $525.
| The entries at each subsequent reporting date are shown below | ||||||
|---|---|---|---|---|---|---|
| 2024 ($) | 2025 ($) | 2026 ($) | 2027 ($) | 2028 ($) | Total ($) | |
| Income statement | ||||||
| Interest expense (1) | -1,516 | -1,246 | -962 | -660 | -340 | -4,725 |
| Depreciation (2) | -5,160 | -5,160 | -5,160 | -5,160 | -5,160 | -25,800 |
| Profit or loss impact | -6,676 | -6,406 | -6,122 | -5,820 | -5,500 | -30,525 |
| Balance sheet | ||||||
| Right of use asset | 20639 | 15479 | 10319 | 5160 | ||
| Lease liability | 20791 | 16038 | 11001 | 5661 | ||
| Notes: (1) Calculated using the incremental borrowing rate of 6% (2) Straight line depreciation based on ROU asset of $25,274 + $525 = $25,799 over 5 year term. |
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The above is a simple example to illustrate the principles in AASB 16. Entities should consider the terms and conditions in their leases that would affect the lease accounting, for example:
- CPI rental increases
- Market rent resets
- Make good clauses
- Variable rents linked to sale or usage of the assets
- Lease incentives
- Extension / termination options affecting the lease term
- Commencement date of the lease.
Significant judgements and estimates
| Applying AASB 16 requires entities to make a number of significant judgements and estimates including: | |
|---|---|
| Lease term | Where the lease includes extension or termination options, is it reasonably certain that these options will be exercised? The lease liability should be calculated over the appropriate term. |
| Interest rate | Most leases do not include an implicit interest rate and therefore entities have to estimate their incremental borrowing rate. This is the rate at which they would be able to borrow funds for the purpose of acquiring the underlying asset over the same time period as the lease. |
| Impairment of right of use asset | the right of use asset is within the scope of AASB 136 Impairment of Assets and therefore the existence of impairment indicators needs to be assessed. If impairment indicators are present, then the recoverable amount of the right of use asset or related cash-generating units needs to be estimated. |
| Some myths about AASB 16 Leases | |
|---|---|
| MYTH | TRUTH |
| AASB 16 accounting is the same as previous finance lease accounting | The required lease accounting under AASB 16 is not the same as the previous finance lease accounting. |
| Entities should ensure that they consider the requirements of AASB 16 and not rely on previous knowledge. | |
| Leases of corporate head offices are excluded from AASB 16 | There is no differentiation in AASB 16 as to the type of assets being leased – if an agreement meets the definition of a lease and is not specifically scoped out then it is included in the AASB 16 accounting treatment. |
| The right of use asset will always be equal to the lease liability | The right of use asset uses lease liability as the base for the calculation, however there are other components to the right of use asset such as lessee’s initial direct costs, prepaid lease payments, lease incentives and restoration provisions. |
| Hire purchase agreements are excluded from AASB 16 | If the agreement meets the definition of a lease and is not specifically scoped out, then it is included in the AASB 16 accounting treatment. |
| AASB 16 is a set and forget standard. | Unfortunately, AASB 16 is not a set and forget standard and in many cases, entities have to perform additional lease calculations annually, for example where there is a CPI clause in the agreement. Examples of other circumstances which will trigger lease recalculations are: · Market rent reviews · Negotiations of lease payments · Increasing or decreasing the assets being leased · Increasing or decreasing the lease term · Modifications to the lease · Signing a new agreement for the same asset. |
Examples of other circumstances which will trigger lease recalculations are:
- Market rent reviews
- Negotiations of lease payments
- Increasing or decreasing the assets being leased
- Increasing or decreasing the lease term
- Modifications to the lease
- Signing a new agreement for the same asset.
Why is AASB 16 not just an accounting issue?
Many of the accounting standards affect the numbers reported but have no impact on the rest of the organisation but AASB 16 is different.
| The team for leases in your organisation should include a range of employees to consider the following issues (not an exhaustive list): | ||
|---|---|---|
| Delegations – who can sign leases? | IT systems – are your systems for recording leases and calculating the accounting entries appropriate? | Does the entity want to buy rather than lease? |
| Are bank covenant calculations including or excluding the impact of AASB 16? | Are any bonus, earn-out or other performance agreements affected by AASB 16? | Has the increase in depreciation affected grant agreements? |
| Does the employee negotiating leases understand the accounting impact of terms and conditions? Consider internal education | Do management accounts reflect the AASB 16 entries or is this a year end adjustment? | Who is reviewing new agreements for embedded leases? |
Do you have more questions about how AASB 16 Leases applies to your business?
Contact the Bentleys team today. We’re here to help you get where you want to be.
Disclaimer: This information is general in nature and should not be relied on as advice. It does not take into account the objectives, financial situation or needs of any particular person. You need to consider your financial situation and needs and seek professional advice before making any decisions based on this information.