The implementation of IFRS 16 (Leases) is around the corner, while IFRS 15 (Revenue from Contracts with Customers) is already in place. It is important that companies start evaluating what impact the introduction of these two accounting standards will have on the Annual Financial Statements as well as on the business as a whole.
The requirements set out in these two standards could have a significant impact on all preparers of financial statements compared to the current accounting polices being applied.
IFRS 16 will apply to any business who even has a simple operating lease (IFRS 16). Below is a brief summary.
Why the need for a new standard? Leases are an important and flexible source of financing. It is estimated that listed companies using IFRS or US GAAP have USD3.3 trillion lease commitments and that over 85% of lease commitments do not appear on the balance sheet.
Due to this it has made it difficult for investors and others to get an accurate understanding of the entity’s lease assets and liabilities, compare companies that lease assets with those that purchase assets or estimate the amount of “off balance sheet” obligations.
With the introduction of IFRS 16, lease accounting is going to significantly change for lessees. Lease accounting for lessors is however remaining relatively unchanged.
The following is a simple summary of what the requirements are in terms of IFRS 16 from a lessee’s perspective.
A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration.
If the customer has the right to control the use then there is a lease.
If the supplier has the right to control the use then there is a service.
A customer has the right to control the use if:
They have the right to direct the use of the asset; and
They have the right to obtain substantially all economic benefits from use of the asset.
If a lease is present then a lessee will be require to recognise a right of use asset and a corresponding lease liability on its statement of financial position.
There are however two optional recognition exemptions available:
Short-term leases. An entity need not recognise the right of use asset or lease liability if the lease term is less than 12 months. An entity is required however to assess the likelihood of the lease being extended beyond 12 months when wanting to apply this exemption.
Leases of low-value assets. Lease assets that are less than $5 000 in value need not be recognised as right of use assets.
If any of the exemptions are taken, the lessee should account for these leases similarly to operating leases in IAS 17.
On initial measurement, the lease liability is calculated as being the lease payments during the lease term multiplied by the discount rate.
The discount rate is:
If readily determinable: rate implicit in the lease.
Otherwise: lessee’s incremental borrowing rate
It is also noted that payments can be either fixed, variable or optional.
Variable payments that depend on sales or use of the underlying asset are not included in calculating the lease liability.
Optional payments that are not reasonably certain to occur are also not included in calculating the lease liability.
For subsequent measurement, the following should be accounted for:
With regards to the right of use asset, the asset will be depreciated over the lease term and assessed for impairment. The depreciation will be recognised in profit or loss.
With regards to the lease liability, the liability will be decreased by the lease payment made and interest expense (discount unwind) will be recognised in profit or loss.
IFRS 16 further details the treatment of lease modification. This however has not been dealt with in this article.
Furthermore, this article does not address the accounting for sale and lease back transactions under IFRS 16.
The effective date of IFRS 16 is for year ends beginning on or after 1 January 2019. An entity’s 31 December 2019 financial statements will need to be prepared applying the requirements of IFRS 16.
There are two transition options available to an entity when applying IFRS 16 for the first time:
Option 1 - Fully retrospective application.
Option 2 - Cumulative catch-up approach. An entity would not restate comparative information and would recognise the cumulative effect in the opening current year Statement of Financial Position.
It should be noted that both options would require similar effort in calculating the cumulative effect of applying IFRS 16.
Partner, RSM Johannesburg