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Accounting for leases: A worked example

In response to feedback from readers to last week's article on accounting for leases, here is a worked example which clearly shows how the new standard works in practice
October 22, 2019

Following some useful feedback from readers on last week’s article about accounting for leases, I will show a practical example as to how the assets, liabilities and income statement expenses associated with them are calculated.

A company signs an agreement with a landlord to rent a property for 10 years at an annual rent of £1m a year. The interest rate in the lease is 6 per cent and there are no break clauses in the agreement.

The initial right-of-use asset and lease liability that will go on the balance sheet are calculated by discounting the future annual rent payments to a present value using a discount rate of 6 per cent.

 

Present value of rent payments

Year

Lease Payment

Discount Factor @ 6%

PV @ 6%

1

£1,000,000

0.943

£943,396

2

£1,000,000

0.890

£889,996

3

£1,000,000

0.840

£839,619

4

£1,000,000

0.792

£792,094

5

£1,000,000

0.747

£747,258

6

£1,000,000

0.705

£704,961

7

£1,000,000

0.665

£665,057

8

£1,000,000

0.627

£627,412

9

£1,000,000

0.592

£591,898

10

£1,000,000

0.558

£558,395

Total

£10,000,000

 

£7,360,087

Source: Investors Chronicle

 

The total £10m of rent to be paid over 10 years has a present value of £7.36m today. A right-of-value asset and lease liability with this amount go on the balance sheet.

Now, under IFRS 16 we need to break down the lease (rent) expenses into separate depreciation and interest payments. 

Let’s deal with depreciation first. In this case, the right-of-use asset will be depreciated on a straight-line basis to zero over the length of the rent agreement (10 years). This gives an annual depreciation expense of £736,009.

 

Right-of-use asset and depreciation

Year

Starting

Depreciation

Closing

1

£7,360,087

-£736,009

£6,624,078

2

£6,624,078

-£736,009

£5,888,070

3

£5,888,070

-£736,009

£5,152,061

4

£5,152,061

-£736,009

£4,416,052

5

£4,416,052

-£736,009

£3,680,044

6

£3,680,044

-£736,009

£2,944,035

7

£2,944,035

-£736,009

£2,208,026

8

£2,208,026

-£736,009

£1,472,017

9

£1,472,017

-£736,009

£736,009

10

£736,009

-£736,009

£0

Source: Investors Chronicle

 

Turning to the liability. This starts out at £7,360,087 as well.  Interest of 6 per cent is charged on the starting balance each year and £1m is paid to the landlord. The lease liability is reduced by the difference between the interest expense and the £1m paid.

 

Lease liability and interest

Year

Starting

Interest @ 6%

Rent paid

Closing

1

£7,360,087

£441,605

-£1,000,000

£6,801,692

2

£6,801,692

£408,102

-£1,000,000

£6,209,794

3

£6,209,794

£372,588

-£1,000,000

£5,582,381

4

£5,582,381

£334,943

-£1,000,000

£4,917,324

5

£4,917,324

£295,039

-£1,000,000

£4,212,364

6

£4,212,364

£252,742

-£1,000,000

£3,465,106

7

£3,465,106

£207,906

-£1,000,000

£2,673,012

8

£2,673,012

£160,381

-£1,000,000

£1,833,393

9

£1,833,393

£110,004

-£1,000,000

£943,396

10

£943,396

£56,604

-£1,000,000

£0

Source: Investors Chronicle

 

As you can see, the interest expense comes down throughout the length of the lease. The liability balance is written down to zero over 10 years.

We can also see that as the right-of-use asset and lease liability decrease at different rates there is a changing impact on the balance sheet over the length of the lease.

 

Balance sheet impact of IFRS 16

Year

Right-of-use asset

Lease liability

Impact on net assets

1

£7,360,087

£7,360,087

£0

2

£6,624,078

£6,801,692

-£177,614

3

£5,888,070

£6,209,794

-£321,724

4

£5,152,061

£5,582,381

-£430,321

5

£4,416,052

£4,917,324

-£501,272

6

£3,680,044

£4,212,364

-£532,320

7

£2,944,035

£3,465,106

-£521,071

8

£2,208,026

£2,673,012

-£464,986

9

£1,472,017

£1,833,393

-£361,375

10

£736,009

£943,396

-£207,388

Source: Investors Chronicle

 

Net assets decrease with the biggest effect in the middle of the lease term.

We can now look at the impact on profits from adopting the new standard compared with expensing £1m a year under the old standard.

 

Profit impact of adopting IFRS 16 leases versus old standard

Year

Depreciation

Interest

Lease expense IAS 16

Operating lease

Profit impact

1

£736,009

£441,605

£1,177,614

£1,000,000

-£177,614

2

£736,009

£408,102

£1,144,110

£1,000,000

-£144,110

3

£736,009

£372,588

£1,108,596

£1,000,000

-£108,596

4

£736,009

£334,943

£1,070,952

£1,000,000

-£70,952

5

£736,009

£295,039

£1,031,048

£1,000,000

-£31,048

6

£736,009

£252,742

£988,751

£1,000,000

£11,249

7

£736,009

£207,906

£943,915

£1,000,000

£56,085

8

£736,009

£160,381

£896,389

£1,000,000

£103,611

9

£736,009

£110,004

£846,012

£1,000,000

£153,988

10

£736,009

£56,604

£792,612

£1,000,000

£207,388

Source: Investors Chronicle

 

In the early years of the lease, expenses are higher and profits are lower than under the old standard. As the lease matures, lease interest expenses fall and total expenses become lower and profits higher than under the old standard. This was the case with Next (NXT) in last week’s article. Companies withmature leases will have higher profits than companies with newer ones.