IFRS 16 - Leases
IFRS 16 is effective for annual periods beginning on or after 1 January 2019 with earlier application permitted, as long as IFRS 15 is also applied.
The changes for lessors, and for lessees under current finance leases, will be limited, but the standard will significantly affect the financial statements of lessees under what are currently treated as operating leases.
The key change is that, with a few exceptions, lessees under current operating leases will be required to:
• record a liability for the payments under the lease; and
• record a right of use asset.
This is similar in principle to the previous accounting treatment for finance leases, with all its attendant implications of front loading charges and changing gearing ratios.
There are minor changes to the scope of the standard, with specific reference to the exclusion of leases that fall within the scope of IFRIC 12 or licences of intellectual property granted by lessors that fall within the scope of IFRS 15.
Of greater importance are two optional exemptions from the requirement to account for a right of use asset and related lease obligation being:
• leases of one year or less that do not contain a purchase option; and
• leases of low value assets, such as PCs and some items of office furniture.
The short-term exemption must be adopted, if at all, by class but the low value exemption is available on an asset by asset basis.
Whilst IFRS 16 contains no reference to amounts, the Basis for Conclusions lets slip that the IASB had in mind an amount of $5,000 when discussing the low value exemption, so no doubt many will try to apply this as a bright line. Where either of these exemptions is taken the accounting treatment will not change from that previously applied to operating leases.
The basic rule remains that the lease payments should be discounted at the interest rate implicit in the lease or, where this is not known to the lessee, then the lessee’s incremental borrowing rate. This amount then provides the liability, whilst the asset starts from this figure to which may be added the present value of any restoration costs and any incremental costs in entering the lease, as well as any lease payments made prior to commencement of lease, minus any lease incentives already received. One thing that will be a little more challenging in respect of those leases that would previously have been treated as operating leases is that it will not usually be possible to “sense check” the asset value arising to the fair value of the asset as a whole, which could broadly be done for finance leases under IAS 17.
What may change, for more complex leases, are the payments included. As before these include fixed amounts, options expected to be exercised, and expected amounts of residual value guarantees from the lessee, but they must now also include two types of variable payment: those based on an index or rate (such as a measure of inflation) and ‘in-substance fixed’ payments (where practically or economically, the payment is unavoidable). Payments based on other variables are excluded, and recognised in profit or loss as incurred (for example, an amount equal to a set percentage of sales actually made). Variable payments based on an index or rate are initially measured using the index or rate at the commencement date of the lease. Subsequent changes are accounted for when the lease payment itself changes. Such variable payments were not treated consistently under IAS 17, and therefore the impact of the change to IFRS 16 will depend on what policies entities previously adopted.
Another change is that IFRS 16 covers changes in lease arrangements in greater depth and far more clearly than IAS 17. These changes can arise due to a reassessment (based on contractual clauses already in the lease) or modification (which involves a re-negotiation between the lessee and lessor). Depending on the nature of the change, reassessments can result in a revision to the discount rate, and a re-measurement of the lease liability results in corresponding adjustment to the right of use asset.
A modification may or may not change the scope of a lease. For example, a negotiation to lease extra space in a building can be contrasted with a negotiated reduction in payments where market conditions have deteriorated. Broadly, modifications result in a re-measurement of the lease liability and an adjustment to the right-of-use asset, except in one case. A separate lease contract is accounted for where the scope of the lease is increased, and the change to the consideration paid is commensurate with the stand-alone price for the increase. There may well be judgement required here, as ‘commensurate’ does not mean ‘equal’, as certain adjustments can be taken into account (such as the lessor’s lower costs when dealing with an existing lessee, as opposed to finding a new lessee).
For lessors, a modification of an operating lease will be accounted for as a new lease. A modification of a finance lease is treated as a separate lease if the same criteria are met as for lessees above. If not, the treatment depends on whether the modification would have resulted in either an operating or finance lease, had it been in effect at the inception of the lease.
There are substantially more disclosure requirements than under IAS 17. Unlike some other aspects of the new standard, these will affect every entity involved in leasing, whether as lessor or lessee and whether lease were previously classified as finance or operating.
There are some transitional provisions. In particular:
• determinations of whether a contract contained a lease under IFRIC 4 do not need to be reconsidered;
• for operating leases for lessees a simplified method can be applied such that rather than full retrospective adjustment an entity can treat leases in place at the date of initial application as though they were entered into at that date, taking account only of payments to be made after that date and allowing other simplifications, such as the use of hindsight and of a portfolio basis;
• where an operating lease has less than a year to run at the date of initial application it can be treated as a short-term lease, without reference to its full term; and
• neither lessees nor lessors with finance leases at the date of initial application need restate the relevant amounts, even if they are affected by the changes in relevant lease payments.
There are also specific transitional provisions dealing with sub-leases and previous sale and leaseback transactions. The standard also points out that if an entity had previously accounted for an asset or liability arising from a favourable or unfavourable operating lease acquired in a business combination then that asset or liability must be eliminated, with a corresponding adjustment to the right of use asset.
To assist companies applying the IFRS 16 please refer to educational and support materials on
website of International Accounting Standards Board.