Spotlight on the new Leases Standard: IFRS 16 in 16 Q&As, by Joelle Moughanni, RSM. Taken from RSM Reporting
1. What’s new?
After an extensive consultation process, the International Accounting Standards Board (IASB) issued IFRS 16 Leases in January 2016, thereby completing its major project to improve the financial reporting of leases. Effective from 1 January 2019, the new Standard replaces IAS 17 Leases and related Interpretations, and sets out the principles for the recognition, measurement, presentation and disclosure of leases for both parties to a contract, i.e. the lessee and the lessor.
For lessees that have entered into contracts classified as operating leases under IAS 17, the new requirements could have a huge impact on the financial statements: almost all leases will be recognised on the balance sheet as a right-of-use asset and a financial liability, with more expenses recognised in profit or loss during the earlier life of a lease, and an associated impact on key accounting metrics. Some industry sectors are expected to be more affected than others, with considerable variations between companies within a sector.
Although IFRS 16 substantially carries forward the lessor accounting requirements in IAS 17, it is likely to have significant business implications.
The accounting change for leases is just the tip of the iceberg. Entities should take advantage of the relatively long implementation period to undertake an in-depth review of the changes and assess the impact on financial ratios and performance metrics (including debt covenants), business operations, systems and data, business processes and controls to understand the implementation issues and contain compliance costs and risk.
2. Why change lease accounting?
Leases are an important and flexible source of financing: listed companies using IFRS or US GAAP are estimated to have around US$3.3 trillion lease commitments, of which more than 85% do not appear today on the balance sheet. Because accounting by lessees under IAS 17 depends on whether the lease qualifies as an operating lease or a finance lease, some leases end up on the balance sheet while most result only in a rent expense in the income statement and no balance sheet items.
Thus, it is difficult for investors and other users of financial statements to get an accurate picture of a company’s lease assets and liabilities, compare companies that lease assets with those that buy assets, and estimate the amount of off balance sheet obligations.
IFRS 16 aims at meeting investors’ needs by making financial reporting for leases more relevant and understandable.
3. What is changing for entities?
In addition to bringing substantial new assets and liabilities onto a lessee’s balance sheet, IFRS 16 will have an effect on reported profit and performance measures. With the changed definition of a lease, it is likely that there will be some additional contracts within the scope of the new Standard, which need to be considered by both lessors and lessees.
For lessees, IFRS 16 eliminates the classification of leases as either operating or finance; instead it introduces a single lessee accounting model.
Lessor accounting is substantially carried forward from IAS 17, with some additional disclosure requirements.
The impact on sectors and individual entities within each industry will vary according to their particular circumstances. Some sectors will be affected more than others, in particular those using off balance sheet leases extensively (e.g. airlines, retailers, transport, and travel and leisure).
4. Are there any exemptions to the new leases accounting model?
Yes. In response to concerns expressed about cost and complexity, IFRS 16 does not require a lessee to recognise assets and liabilities for short‑term leases, and for leases of low-value items. If the exemptions are used (both are optional), then the current IAS 17 operating lease accounting is applied (i.e. rent expense is recognised in the income statement on a straight-line basis).
Short-term leases are defined as leases with a lease term of 12 months or less and containing no purchase options. If a lessee elects this exemption, it must apply it by class of underlying asset, and treat any subsequent modification or change in lease term as resulting in a new lease.
For leases of underlying assets of low value, IFRS 16 does not define the term ‘low value’, but the Basis for Conclusions explains that the Board had in mind assets of a value of US$5,000 or less when new. Examples of assets of low value are personal computers, telephones and small items of office furniture. The exemption is not applicable for certain assets that are dependent on, or highly interrelated with, other underlying assets. The election can be made on a lease-by-lease basis, and it does not take into account whether low-value assets in aggregate are material. Accordingly, although the aggregated value of the assets captured by the exemption may be material the exemption is still available.
In addition, both lessees and lessors can apply IFRS 16 accounting to a portfolio of leases with similar characteristics if the entity reasonably expects that the resulting effect is not materially different from applying the Standard on a lease-by-lease basis.
5. Is the definition of a lease changed under IFRS 16?
IFRS 16 retains the definition of a lease in IAS 17, but changes the guidance setting out how to apply it. The changes are not expected to affect conclusions about whether contracts contain a lease for the vast majority of contracts (i.e. a lease under IAS 17 is generally expected to be a lease applying IFRS 16). However, it is expected that IFRS 16 will exclude from its scope a number of service contracts that may have been considered to be leases applying IAS 17 (e.g. some supply contracts).
IFRS 16 defines a lease as a contract that conveys to the customer (i.e. the lessee) the right to use an asset for a period of time in exchange for consideration (the ‘right-of-use model’). A lease exists when a customer controls the right to use an identified asset, which is when the customer has the right to obtain substantially all of the economic benefits from the use of the asset and the right to direct the use of the asset, i.e. to decide how and for what purpose it is used.
Judgements will apply often with a focus on whether an asset is identified. An asset might appear to be explicitly or implicitly specified by being made available, but it will be necessary to establish whether the supplier has the ability to substitute an alternative asset during the period of the contract. If the supplier can practically substitute another asset (excluding any obligation to replace a defective asset) and there is a clear economic benefit for the supplier to do so, it will not be considered specific and therefore the contract would not be considered a lease.
At first sight, the definition looks straightforward. But, in practice, it can be challenging to assess whether a contract conveys the right to use an asset or is, instead, a contract for a service that is provided using the asset. In a lease contract, it is the customer who controls the use of the item, as opposed to a service contract in which the supplier controls the use of the item.
The definition of a lease is now much more driven by the question of which party to the contract controls the use of the underlying asset for the period of use. It is not sufficient any more for a customer to have the right to obtain substantially all of the benefits from the use of an asset; the customer must also have the ability to direct the use of the asset.
6. What will IFRS 16 change for lessees in particular?
Lessees will no longer distinguish between finance lease contracts (on balance sheet) and operating lease contracts (off balance sheet), but they are required to recognise a right-of-use (ROU) asset and a corresponding lease liability for almost all lease contracts. This is based on the principle that, in economic terms, any lease contract is the acquisition of a right to use an underlying asset with the purchase price paid in instalments. Consequently, lessees will account for all of their leases in a manner similar to how finance leases are currently treated applying IAS 17.
The most obvious effect of this approach is a substantial increase in the amount of recognised assets and financial liabilities for entities that have entered into significant lease contracts that are currently classified as operating leases under IAS 17. Thus, under the new accounting model, a lessee will:
- recognise in the balance sheet ROU assets and lease liabilities,
- recognise in the income statement depreciation of ROU assets and interest on lease liabilities,
- present in the cash flow statement the amount of cash paid for the principal portion of the lease liability within financing activities, and the amount paid for the interest portion within either operating or financing activities (in accordance with IAS 7), and
- disclose relevant information: breakdown of lease costs, information on lease cash flows, maturity analysis of undiscounted commitments, information on ROU assets by major class of underlying asset, etc.
7. How are lease liabilities measured and recognised?
IFRS 16 requires a lessee to recognise the lease liability at the commencement day and to measure it at an amount equal to the present value of future lease payments. However, to reflect the flexibility obtained by a lessee (e.g. extension options, or payments that vary based on sales or the use of an asset) and to reduce complexity, lease liabilities include only economically unavoidable payments. Thus, lease liabilities include fixed payments, variable lease payments that depend on an index or a rate, and only those optional payments that the lessee is reasonably certain to make. Lease liabilities exclude variable lease payments linked to sales or use; such payments are simply expensed as incurred rather than being estimated up-front.
In subsequent periods, the lease liability is measured using the effective interest rate method.
8. How are lease assets measured and recognised?
The ROU asset is recognised at the commencement day and measured at cost, consisting of the amount of the initial measurement of the lease liability, plus (i) any lease payments made to the lessor at or before the commencement date, (ii) the initial estimate of restoration costs and (iii) any initial direct costs incurred by the lessee, and less any lease incentives received.
Subsequently, the ROU asset is depreciated in accordance with the requirements in IAS 16 Property, Plant and Equipment (i.e. on a straight-line basis or another systematic basis) and submitted to the impairment requirements in IAS 36 Impairment of Assets. However, IFRS 16 contains two alternatives to the cost model:
A ROU asset that meets the definition of investment property must be subsequently measured in accordance with the fair value model in IAS 40 if the lessee has elected the fair value model in IAS 40 for its investment property.
A ROU asset can be subsequently measured at the revalued amount in accordance with IAS 16 if it relates to a class of PPE to which the lessee applies the revaluation model.
9. How is the lease term determined?
IFRS 16 defines a lease term as the non-cancellable period for which the lessee has the right to use an underlying asset, including optional periods when the lessee is reasonably certain to exercise an option to extend (or not to terminate) a lease.
Entities need to consider all relevant facts and circumstances that create an economic incentive for the lessee to exercise the option when determining the lease term. The option to extend the lease term should be included in the lease term if it is reasonably certain that the lessee will exercise the option.
IFRS 16 has a similar definition of lease term to IAS 17, in particular it is still based on a reasonable certainty threshold, but with clarification that periods covered by a termination option are included if it is reasonably certain the termination option will not be exercised.
A lessee is required to reassess the option when significant events or changes in circumstances occur that are within the control of the lessee.
10. What about contracts that contain both leases and services (e.g. lease of a car with maintenance services)?
Leases are different from service contracts: while a lease provides a customer with the right to control the use of an asset, the supplier retains such control in a service contract.
Currently, many companies that have contracts which include both an operating lease and a service do not separate the operating lease component. This is because the accounting for an operating lease and a service/supply arrangement is the same (that is, there is no recognition on the balance sheet and straight-line expense is recognised in profit or loss over the contract period). Under IFRS 16, the treatment of the two components will differ, and thus the components must be separated (IFRS 16 applies only to the lease components).
The requirements of IFRS 16 for separating lease and non-lease components and allocating the consideration to separate components will require management judgement when identifying those components and applying estimates to determine the observable standalone prices.
Only the amounts that relate to the lease will have to be capitalised on the lessee’s balance sheet, as IFRS 16 does not change accounting for services.
As a practical expedient, a lessee may decide by class of underlying asset not to separate non-lease components (services) from lease components; then, each lease component and any associated non-lease component is accounted for as a single lease component. So the service component will either be separated or the entire contract will be treated as a lease.
11. What does IFRS 16 change for lessors?
There is little change for lessors, as the IASB decided to substantially carry forward the lessor accounting requirements in IAS 17. Applying IFRS 16, a lessor continues to classify its leases as operating leases or finance leases, depending on whether substantially all of the risk and rewards incidental to ownership of the underlying asset have been transferred, and to account for those two types of leases differently.
Although accounting remains substantially the same for lessors, the changes made by the new Standard are still relevant. In particular, lessors should be aware of the new guidance on the definition of a lease, subleases and the accounting for sale and leaseback transactions.
IFRS 16 also requires lessors to provide enhanced disclosures about their risk exposure arising from leasing activities.
It is worth mentioning that the changes in lessee accounting might also have an impact on lessors as lessee’s needs and behaviours change.
12. When and how does IFRS 16 become effective, in particular is there any relief on transition?
IFRS 16 replaces IAS 17, effective for annual periods beginning on or after 1 January 2019, with substantive transition relief for companies. Early application is permitted, as long as IFRS 15 Revenue from Contracts with Customers is also applied.
A lessor is not required to make any adjustments on transition and shall account for its leases applying IFRS 16 from the date of initial application. An entity does not reassess sale and leaseback transactions entered into before the date of initial application to determine whether the transfer of the underlying asset satisfies the requirements in IFRS 15 to be accounted for as a sale.
On transition, a lessee may choose to retain existing accounting treatment for existing finance leases. For existing operating leases, a lessee may choose between a full retrospective approach and a modified retrospective approach. The latter includes an exemption from recognising lease assets and liabilities for leases ending within 12 months of transition date, an exemption from restatement of comparatives (instead, opening equity is adjusted for the catch-up effect), and a choice (on a lease-by-lease basis) of measurement of ROU assets (as if IFRS 16 had always been applied or at an amount based on the lease liability).
In addition, lessees and lessors are not required to reassess whether existing contracts contain a lease based on the revised definition of a lease, but can choose to carry forward the assessments under IFRIC 4 and IAS 17, and apply the definition of a lease only to new contracts entered into after the date of initial application.
13. What about presentation and disclosures?
Unlike IAS 17, IFRS 16 does not include a list of prescriptive disclosures. Instead, it sets out objectives and requires companies to determine the information that would satisfy those objectives.
Lease liabilities are considered to be financial liabilities that should be disclosed separately from other liabilities. Applying the requirements in IAS 1, a lessee is required to present lease liabilities as a separate line item, or together with other similar liabilities, in a manner that is relevant to understanding the lessee’s financial position. A lessee will also split lease liabilities into current and non‑current portions, based on the timing of payments.
A lessee should present lease assets on the balance sheet either together with owned property, plant and equipment, or as their own line item(s) if that is relevant to understanding the lessee’s financial position.
Applying the new model, the income statement will disaggregate the presentation of lease expenses for former off balance sheet leases (i.e. splitting the expense into two components) and in a manner that explicitly recognises the financing element inherent in leases. This will change the pattern of expense recognition on an individual lease.
IFRS 16 relies on the requirements of IFRS 7 Financial Instruments: Disclosure for the disclosure of a maturity analysis of lease liabilities. This means that the same approach a company takes to analyse its other financial liabilities should apply to lease liabilities (e.g. judgement in determining which time bands should be disclosed to provide useful information to investors).
In addition, for leases that contain complex features (e.g. variable lease payments, extension options and residual value guarantees), IFRS 16 requires a company to disclose material company-specific information that is not covered elsewhere in the financial statements.
14. How will subleases and sale and lease back transactions be reflected under IFRS 16?
A common scenario is for properties to be leased by an intermediate company and subleased to an occupier, or for properties to be leased and partially occupied with the remainder sublet. The intermediate lessor/lessee will assess whether the sublease is a finance or operating lease by reference to the value and economic life of its ROU asset. When the sublease is classified as a finance lease, the appropriate portion of the ROU asset will be derecognised and the net investment in the sublease recognised. Any difference will be recognised in profit or loss.
Many companies use sale and leaseback transactions of property as a means of raising finance. Under IFRS 16, the immediate gain recognised on such transactions will be lower than before. Whether there is a sale will be determined under IFRS 15, and if so an asset recognised for the ROU leased back. However, the gain on such transactions will only reflect the extent to which the ROU has transferred, i.e. the ROU asset retained by the seller will be reflected as a portion of its previous carrying amount.
15. What about convergence with US GAAP?
Convergence has been a priority for both IASB and FASB (the Boards) throughout the Leases project: joint deliberations, joint proposals for public consultation (the 2009 Discussion Paper, and the 2010 and 2013 Exposure Drafts), joint outreach, etc.
The Boards reached the same conclusions in many areas of lease accounting: definition of a lease, recognition and measurement of lease assets and liabilities, carry forward of previous lessor accounting, etc. However, they reached different conclusions in a few areas, most importantly on lessee expense recognition: FASB decided to retain a dual accounting model for lessee vs a single model for IASB. Consequently, the income statement and cash flow statement will look very different using one GAAP or the other.
16. To summarise, what are the key changes to expect from IFRS 16?
There is no doubt that lessees will be greatly affected by the new leases Standard. Although lessors’ accounting largely remains unchanged, lessors might see an impact on their business model and lease products due to changes in needs and behaviours if companies decide to buy more assets and, as a consequence, lease fewer assets, or turn more to services rather than assets. IFRS 16 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, 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.
The key changes to expect are the following:
- Balance sheets will get bigger - By bringing lease assets and liabilities onto the balance sheet, companies with material off balance sheet leases will report higher assets and financial liabilities than they currently do.
- The income statement will offer more detail - The new model will align the income statement expense treatment for all leases by replacing today’s straight-line operating lease expense with a depreciation charge for the ROU asset and an interest expense on the lease liability.
- Financial ratio analysis will be affected - The changes to presentation of lease expense will be noticeable to investors when analysing ratios such as EBITDA margin. This is because, unlike under IAS 17, EBITDA calculated under IFRS 16 does not include expenses related to leases.
- Improved disclosures about leases - Because the information presented today is considered by many to be inadequate, improving the quality of disclosures was necessary. Among the new disclosures investors can look forward to are more details about the lease expense and lease assets by class of asset. IFRS 16 also requires disclosure of a maturity analysis of lease liabilities similar to that for all financial liabilities. For both lessees and lessors, IFRS 16 adds significant new, enhanced disclosure requirements.
Since changes in accounting requirements do not change the amount of cash transferred between the parties to a lease, IFRS 16 will not have any effect on the total amount of cash flows reported. However, IFRS 16 is expected to have an effect on the presentation of cash flows related to former off balance sheet leases, reducing operating cash outflows, with a corresponding increase in financing cash outflows, compared to the amounts reported when applying IAS 17.
For an individual former off balance sheet lease, IFRS 16 results in a different total expense recognition pattern compared to IAS 17. This is because interest expense is typically higher in the earlier years of a lease than in the later years. When combined with typically straight-line depreciation of lease assets, this results in a total lease-related expense (interest plus depreciation) that is higher than a straight-line lease expense during the first half of the lease term. The opposite is true in the second half of the lease term. Over the lease term, the total amount of expense recognised is the same.