IFRS 16 is the result of the joint project initiated by the IASB together with the U.S. national standard‑setter, the Financial Accounting Standards Board (FASB), to address concerns raised by users of financial statements in respect of reduced comparability between financial statements due to the very different accounting applied to operating and finance leases and limitations in the information provided on operating leases and on entities’ exposure to risks arising from lease arrangements.

The Standard provides a comprehensive model for the identification of lease arrangements and their treatment in the financial statements of both lessees and lessors. It supersedes IAS 17 Leases and its associated interpretative guidance.

SCOPE OF THE STANDARD

The scope of IFRS 16 is generally similar to IAS 17 and includes all leases that convey the right to use an asset for a period of time in exchange for consideration, including leases of right-of-use assets in a sublease, except for:

(a) leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources;

(b) leases of biological assets within the scope of IAS 41 Agriculture held by a lessee;

(c) service concession arrangements within the scope of IFRIC 12 Service Concession Arrangements

(d) licences of intellectual property granted by a lessor within the scope of IFRS 15 Revenue from Contracts with Customers; and

(e) rights held by a lessee under licensing agreements within the scope of IAS 38 Intangible Assets for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights.

A lessee may, but is not required to, apply this Standard to leases of intangible assets other than those described in paragraph e above.

Exemption from measurement requirement

As a practical expedient, the standard allows short‑term leases and leases of low value assets to be accounted for by simply recognising an expense, typically straight‑line, over the lease term. A ‘short term lease’ is defined as one that does not include a purchase option and has a lease term at commencement date of 12 months or less.

RECOGNITION AND MEASUREMENT REQUIREMENTS

Definition of a Lease

A contract is, or contains, a lease if the contract provides a customer with the right to control the use of the identified asset for a period of time in exchange for consideration. Control is considered to exist if the customer has:

(a) the right to obtain substantially all of the economic benefits from use of an identified asset; and

(b) the right to direct the use of that asset.

Identifying a Lease contract

An entity is required to identify whether a contract is, or contains, a lease at inception and it will only reassess whether the contract is or contains a lease in case of a modification to the terms and conditions of the contract. The inception of a lease is the earlier of the date of a lease agreement and the date of commitment by the parties to the principal terms and conditions of the lease.

The Standard aims to distinguish a lease from a service contract on the basis of whether a customer is able to control the asset being leased. For a contract to be a lease under IFRS 16, it must include the following:

1. Use of an identified asset– An asset is typically identified if it is explicitly specified in a contract or implicitly specified at the time the asset is made available for use by the customer. However, if the supplier has substantive rights to substitute the asset throughout the period of use then the asset is not considered to be ‘identified’.

2. Lessee’s right to direct the use of the asset- A customer has the right to direct the use of an identified asset throughout the period of use only if either:

• the customer has the right to direct how and for what purpose the asset is used throughout the period of use; or

• the relevant decisions about how and for what purpose the asset is used are predetermined and:

• the customer has the right to operate the asset throughout the period of use; or
• the customer designed the asset in a way that predetermines how and for what purpose the asset will be used.

3. Right to obtain economic benefits from use of the identified asset- To control the use of an identified asset, a customer is required to have the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use. The economic benefits from use of an asset include its primary output and by‑products, and other economic benefits from using the asset that could be realised from a commercial transaction with a third party.

Accounting for a Lease contract

Under IFRS 16, lessees will recognise a right of use asset and an associated liability at the inception of the lease. The standard requires that the ‘right of use asset’ and the lease liability should initially be measured at the present value of the minimum lease payments. The discount rate used to determine present value should be the rate of interest implicit in the lease.

Right‑of‑use asset

A lessee is required to include the following items as part of the costs of the right‑of‑use assets:

• the amount of the initial measurement of the lease liability (see below);
• any lease payments made to the lessor at or before the commencement date, less any lease incentives;
• any initial direct costs incurred by the lessee; and
• an estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions of the lease, unless those costs are incurred to produce inventories (in which case they would be accounted for in accordance with IAS 2 – Inventories). Costs of this nature are recognised only when an entity incurs an obligation for them. IAS 37 – Provisions, Contingent Liabilities and Contingent Assets would be applied to ascertain if an obligation existed.

Subsequently, the right of use asset is depreciated over the shorter of the useful life of the asset and the lease term, unless the title to the asset transfers at the end of the lease term, in which case depreciation is over the useful life.

Lease liability

An entity will measure the lease liability at the present value of lease payments discounted using the rate implicit in the lease if that rate can be readily determined. If an entity is unable to estimate the rate implicit in the lease, then the lessee should use its incremental borrowing rate.

Accounting for leases in the financial statements of lessors

The Standard maintains substantially the lessor accounting requirements in IAS 17 Leases.

The Standard requires a lessor to classify a lease either as an operating lease or a finance lease (IFRS 16.61).

A lessor is required to recognise at the commencement date assets held under a finance lease in its Statement of financial position and present them as a receivable at an amount equal to the net investment in the lease. The net investment in the lease will be measured as the sum of both of the following:

• the lease receivable measured at the present value of the lease payments; and
• the residual asset, measured at the present value of any residual value accruing to the lessor.

Subsequently, a lessor is required to recognise finance income over the lease term, based on a pattern reflecting a constant periodic rate of return on the lessor’s net investment in the lease.

A lessor is required to recognise lease payments from operating leases as income on either a straight‑line basis or another systematic basis. Another systematic basis should be applied if that basis is more representative of the pattern in which benefit from the use of the underlying asset is diminished.

IMPACT OF THE STANDARD

The impact on a lessee’s financial reporting, asset financing, IT, systems, processes and controls is expected to be substantial. The pervasive impact of these rules requires companies to transform their business processes in many areas, including finance and accounting, IT, procurement, tax, treasury, legal, operations, corporate real estate and HR. However, the lessors’ accounting largely remains unchanged.

Specific areas expected to be affected by the standard include:

Lessees

• The new standard will affect virtually all commonly used financial ratios and performance metrics such as gearing, current ratio, asset turnover, interest cover, EBITDA, EBIT, operating profit, net income, EPS, ROCE, ROE and operating cash flows. These changes may affect loan covenants, credit ratings and borrowing costs, and could result in other behavioural changes. These impacts may compel many organisations to reassess certain ‘lease versus buy’ decisions.

• Balance sheets will grow, gearing ratios will increase, and capital ratios will decrease. There will also be a change to both the expense character (rent expenses replaced with depreciation and interest expense) and recognition pattern (acceleration of lease expense relative to the recognition pattern for operating leases today).

• Entities leasing ‘big-ticket’ assets – including real estate, manufacturing equipment, aircraft, trains, ships, and technology – are expected to be greatly affected. The impact for entities with numerous small leases, such as tablets and personal computers, small items of office furniture and telephones might be less as the IASB offers an exemption for low value assets (assets with a value of $5,000 or less when new). Low value assets meeting this exemption do not have to be recognised on the balance sheet.

• The cost to implement and continue to comply with the new leases standard could be significant for most lessees. Particularly if they do not already have an in-house lease information system.

Lessor

• Lessees and lessors may need to consider renegotiating or restructuring existing and future leases.
• Business and legal structures supporting leases should also be reassessed to evaluate whether these continue to be effective (for example, joint ventures and special purpose entities).
• Lessor accounting remains largely unchanged from IAS 17 however, lessors are expected to be affected due to the changed needs and behaviours from customers which impacts their business model and lease products.

HOW MAC ADEBOWALE CAN HELP

Our Accounting and Advisory service can assist management to successfully navigate and implement this complex new standard. We can assist in performing a robust assessment on the operations and financial reporting of organizations involved in lease arrangements.