HKFRS 16 and the Hong Kong office lease: what your company must book

HKFRS 16 Lease Accounting for Hong Kong Office Leases

How HKFRS 16 Applies to a Hong Kong Office Lease

HKFRS 16, issued by the Hong Kong Institute of Certified Public Accountants (HKICPA), governs how a Hong Kong company accounts for its office lease. For most companies, the effect is to bring nearly all leases onto the statement of financial position. The core principle: a lessee recognises a right-of-use asset and a lease liability at the commencement date of the lease. The exact phrase "hkfrs 16 hong kong office lease" describes the specific application of the standard to the most common type of lease held by Hong Kong businesses. Take a three-year office lease as the working model.

Lease Accounting Hong Kong HKFRS 16: The Basic Model

A lessee must recognise a right-of-use asset and a lease liability for all leases, unless an exemption applies. Measure the lease liability at the present value of the lease payments not yet paid. Discount using the lessee's incremental borrowing rate if the rate implicit in the lease is not readily determinable. Measure the right-of-use asset initially at the amount of the lease liability, adjusted for any lease payments made at or before the commencement date, plus any initial direct costs incurred by the lessee.

For a typical Hong Kong office lease, the lease term is fixed (e.g., three years) and the lease payments are stated in the tenancy agreement. Identify the lease term. That term includes any periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option. The incremental borrowing rate is the rate the company would have to pay to borrow the funds necessary to obtain an asset of similar value over a similar term, in a similar economic environment.

Right-of-Use Asset Hong Kong: Initial Recognition and Measurement

The right-of-use asset represents the lessee's right to use the leased office space over the lease term. Recognise this asset on the statement of financial position as a non-current asset. Two exemptions exist: a lease term of 12 months or less (a short-term lease), or an underlying asset of low value.

The initial measurement of the right-of-use asset is the sum of:

• The initial measurement of the lease liability.
• Any lease payments made to the lessor at or before the commencement date, minus any lease incentives received.
• Any initial direct costs incurred by the lessee (e.g., legal fees, commission).
• An estimate of costs to dismantle and remove the underlying asset or restore the site, if the lessee is obliged to do so.

For a standard Hong Kong office lease, the right-of-use asset is the present value of the three years of rent payments, plus any stamp duty or agent fees paid by the tenant.

Hong Kong Lease Liability: Subsequent Measurement

After initial recognition, measure the lease liability at amortised cost using the effective interest method. Each period, the company recognises interest expense on the lease liability. The lease payments made reduce the liability.

The journal entries for subsequent measurement are:

• Dr Interest expense (profit or loss)
• Cr Lease liability (statement of financial position)

When the company pays the monthly rent:

• Dr Lease liability (statement of financial position)
• Cr Cash (statement of cash flows)

Calculate the interest expense by applying the incremental borrowing rate to the outstanding lease liability balance at the start of each period. Over the lease term, the lease liability decreases as payments are made and interest is recognised.

Depreciation of the Right-of-Use Asset

Depreciate the right-of-use asset over the shorter of the lease term and the useful life of the underlying asset. For an office lease, the useful life of the office space is longer than the lease term. Depreciate the asset over the lease term.

Recognise the depreciation charge in profit or loss each period. The journal entry is:

• Dr Depreciation expense (profit or loss)
• Cr Accumulated depreciation - right-of-use asset (statement of financial position)

The depreciation method should reflect the pattern in which the lessee expects to consume the asset's future economic benefits. Use the straight-line method.

Impact on Profit or Loss and Cash Flow

Under HKFRS 16, the total expense recognised in profit or loss for a lease is higher in the early years of the lease term. Interest expense is higher when the lease liability is larger. The depreciation charge is straight-line. This front-loading of expense is a key difference from the previous standard, HKAS 17, which recognised a straight-line operating lease expense.

In the statement of cash flows, split the lease payments:

• Classify the portion of the lease payment that represents the principal repayment as a financing activity.
• Classify the portion that represents interest expense as either operating or financing activity, in accordance with the company's accounting policy.

The right-of-use asset and lease liability do not appear on the cash flow statement directly. Disclose the cash flows from the lease.

Short-Term Lease and Low-Value Asset Exemptions

HKFRS 16 provides two practical expedients. A lessee may elect:

• Short-term lease exemption: Do not recognise a right-of-use asset and lease liability for leases with a lease term of 12 months or less. Recognise the lease payments as an expense on a straight-line basis over the lease term.
• Low-value asset exemption: Do not recognise a right-of-use asset and lease liability for leases of low-value assets (e.g., small items of office equipment). The threshold for low value is US$5,000 or less per item.

For a Hong Kong office lease, the short-term lease exemption is unlikely to apply because office leases are for more than 12 months. A company might use the low-value asset exemption for leases of small office furniture or IT equipment.

Contrast with SME-FRS for Reporting-Exempt Companies

A company that qualifies for the reporting exemption under section 359 of the Companies Ordinance may apply the SME Financial Reporting Framework and Standard (SME-FRF and SME-FRS) instead of full HKFRS. Under SME-FRS, the treatment of leases is simpler.

A lessee classifies leases as either finance leases or operating leases. An operating lease is not recognised on the statement of financial position. Recognise the lease payments as an expense on a straight-line basis over the lease term. For a reporting-exempt company with a three-year office lease, the accounting treatment is the same as under the old HKAS 17: no right-of-use asset or lease liability is recognised, and the rent expense is recognised evenly over the three years.

This is a significant difference from full HKFRS 16. A company that is not reporting-exempt must recognise the right-of-use asset and lease liability. That increases its total assets and liabilities and front-loads the expense. A reporting-exempt company avoids this complexity.

Practical Implications for Statutory Audit and Financial Statements

The application of HKFRS 16 to office leases affects the statutory audit. The auditor will review the company's lease agreements to ensure that all leases are correctly identified and that the right-of-use asset and lease liability are measured correctly. The auditor will also check that the incremental borrowing rate used is appropriate and that the lease term is correctly determined.

The financial statements must include disclosures about the right-of-use asset, lease liability, depreciation, interest expense, and the maturity analysis of the lease liability. HKFRS 16 requires these disclosures. They form part of the notes to the financial statements.

For a company subject to a statutory audit, the auditor's report will cover the lease accounting treatment. If the company has incorrectly applied HKFRS 16, the auditor may issue a modified opinion.

Key Vocabulary for Compliance

When preparing accounting records and financial statements under HKFRS 16, the following terms are essential:

• Right-of-use asset: The asset representing the lessee's right to use the leased office space.
• Lease liability: The present value of the future lease payments.
• Lease term: The non-cancellable period of the lease, plus any extension options the lessee is reasonably certain to exercise.
• Incremental borrowing rate: The rate the lessee would have to pay to borrow funds to obtain a similar asset over a similar term.
• Short-term lease: A lease with a term of 12 months or less.
• Low-value asset: An asset with a value of US$5,000 or less when new.

These terms appear in the accounting records, the financial statements, and the auditor's report. The HKICPA provides guidance on the application of HKFRS 16. The Companies Registry requires that financial statements comply with the applicable financial reporting framework.