On 13 January 2016, the International Accounting Standards Board (IASB) has issued a new ‘leases’ standard- IFRS 16, Leases. The standard requires lessees to recognise most leases on their balance sheets, thus, resulting in increase in the assets and liabilities presented on the balance sheet.Accounting of lease for lessors remains substantially unchanged, i.e., for lessors, there is little change to the existing accounting under IAS 17,Leases. IFRS 16 is effective from 1 January 2019 with an early adoption permitted subject to adoption of IFRS 15, Revenue from Contracts with Customers at the same date.
Accounting for lease by the lessee is based on a ‘single’ lease accounting model for all leases (subject to limited exemptions) with no requirement of classifying the lease into (a) operating lease and (b) finance lease, unlike the current requirement under IAS 17 which is based on ‘dual’ lease accounting model in case of lessees.
Assessment of whether a contract is, or contains, a lease is made at the inception of the contract. Under IFRS 16, 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. Thus, IFRS 16 is based on ‘control’ model unlike IAS 17 which is based on ‘risks and rewards’ model, e.g., pricing mechanisms are relevant for lease classification under IAS 17, however, under IFRS 16, the same is relevant only for measurement of asset and liability.
Use of an Identified Asset
It is consistent to the concept of ‘specific asset’ under IFRIC 4, Determining whether an Arrangement contains a Lease. The asset under IFRS 16 can be explicitly or implicitly identified in a contract. It can even be a portion of a larger asset which is physically distinct, e.g., a floor of a building. However, the identified asset cannot be a capacity portion of a larger asset if that portion is not physically distinct, e.g., 20% capacity portion of a pipeline.
A contract will not involve the use of an identified asset if a supplier has a substantive substitution right which focuses on whether the supplier has the practical ability to substitute the asset and would benefit economically from doing so.
Example: A company provides accounting outsourcing services through a centralised office that involve the use of a specified server. However, the company maintains identical servers in the same office and can easily substitute another server without customer’s approval and such a substitution would benefit the company since it provides flexibility to optimise the performance of its network. Accordingly, fulfilment of such a contract is not dependent of the use an ‘identified’ asset, and thus, would not qualify as a lease. However, if the company does not have the practical ability to substitute the server, e.g., the server being highly customised and substitution would require significant costs without benefiting the company, the contract can be said to be dependent on the use of an ‘identified’ asset.
This condition of ‘substantive’ substitution right has been incorporated to reduce the risk of non-substantive break clauses being inserted within contracts solely for accounting purposes.
Right to Control the Use of the Identified Asset
To control the use of an asset, a customer is required to have:
- the right to obtain substantially all of the economic benefits from use of an asset throughout the period of use (a ‘benefits’ element); and
- the ability to direct the use of that asset (a ‘power’ element)
A customer should consider benefits relating to the use of the asset, e.g., renewable energy credits, by-products from the use of an asset. When considering whether a contract contains a lease, a customer should not consider economic benefits relating to ownership of an asset, e.g., tax benefits as a result of owning an asset.
A customer has the right to direct the use of an asset if it has the right to direct ‘how’ and ‘for what purpose’ the asset is used throughout the period of use. However, supplier’s protective rights generally would not affect the existence of the customer’s right to direct the use of the asset, e.g., terms and conditions in the contract to protect the supplier’s interest in the underlying asset, to protect its personnel or to ensure the supplier’s compliance with applicable laws and regulations. Such protective rights define the scope of the rights obtained by a customer, thus, may affect the price paid for the lease, without preventing a customer from having the right to direct the use of that asset.
In this regard, it may be noted that IFRIC 4 only required meeting condition (a) above, i.e., condition (b) is not present under IFRIC 4.
Example: A customer has entered into a contract with a supplier to use a specified car for two years’ period. The supplier cannot substitute another vehicle except in case of break-down of car. The customer can drive the car or may hire a driver. The customer can decide how to use the vehicle (subject to certain conditions imposed by the supplier, discussed below). In addition, the customer can decide where the car goes, as well as when or whether it is used, and what it is used for, throughout the period of use and the customer can also change its decisions throughout the period of use. Under the contract, the supplier provides scheduled maintenance services and specifies that the customer can use car for a maximum of 12,000 miles in a year without substantive penalty. In addition, the supplier prohibits certain uses of the car (e.g., moving it overseas) and modifications of the car to protect its interest in the asset. In such a case, the customer has the right to direct the use of the car. The supplier’s limitations on annual mileage and certain uses for the vehicle are considered protective rights that define the scope of the customer’s use of the asset but do not affect the assessment of whether the customer directs the use of the asset.
Recognition & Measurement Principles
At the commencement date, a lessee recognises a right-of-use asset and a lease liability.Initially, the right-of-use asset is measured at cost whereas the lease liabilities measured at the present value of the lease payments that are unpaid at that date using a specified discount rate (i.e., interest rate implicit in the lease, or lessee’s incremental borrowing rate, as the case may be). Subsequent measurement of right-of-use asset is generally based on cost model (i.e., at cost less any accumulated depreciation and any accumulated impairment losses). However, under the following two scenarios, use of fair value model is required:
- right-of-use assets that meet the definition of investment property accounted for under fair value model in accordance with IAS 40
- right-of-use assets relating to a class of property, plant and equipment accounted for under revaluation model in accordance with IAS 16
Also, the lessee will reduce the lease liability for lease payments made. Interest expense and depreciation will be recognised in the statement of profit and loss.
Right-of-use assets should be presented in the statement of financial position in either of the two ways:
- separately from other assets
- within the same line item in which the corresponding owned underlying asset would be presented (subject to necessary disclosures)
Similarly, lease liabilities should be presented separately from other liabilities; else lessee needs to disclose the line item in which the lease liabilities have been included.
IFRS 16 contains disclosure requirements for lessees. Lessees will need to apply judgement in deciding upon the information to disclose to meet the objective of providing a basis for users of financial statements to assess the effect that leases have on the financial position, financial performance and cash flows of the lessee.
 Cost of the right-to-use asset comprises the initial amount of lease liability, lease payments (reduced by lease incentives) at or before commencement date, initial direct costs and estimate of dismantling costs.
Variable lease payments that depend on an index or a rate should be measured initially based on the spot rate.
IFRS 16 provides a practical expedient (i.e., exemption from the applicability of recognition principles of IFRS 16) in the following two cases.The recognition exemption has been provided considering the cost vs. benefit analysis of application of IFRS 16 on such leases.
- short-term leases (i.e., a lease having a maximum possible term of 12 months), e.g., a lease with a 10 months’ non-cancellable term with the option to extend the lease for another 3 months, however, at the commencement date the option to extend the lease is not considered reasonably certain
The election for short-term leases should be made by class of underlying asset to which the right of use relates.
- leases for which the underlying asset is of low value (i.e., value of a new underlying asset being USD 5,000 or less, even if they are material in aggregate), e.g., leases of tablet and personal computers, small items of office furniture and telephones
The election for leases for which the underlying asset is of low value can be made on a lease-by-lease basis.
In case of lessee opting for the exemption under IFRS 16 (in the above two cases), the lessee should recognise the lease payments associated with those leases as an expense on either a straight-line basis over the lease term or another systematic basis if that basis is more representative of the pattern of the lessee’s benefit. In simple words, it would be accounted for as an operating lease under IAS 17. If the impact of the above two exemptions is material, disclosure requirements under IFRS 16 should be applicable.
 A class of underlying asset is a grouping of underlying assets of a similar nature and use in an entity’s operations.
Accounting for lessee and lessor has not been mirrored. Based on the respondents’ comments and IASB discussion, it was assessed that the cost of changing the lessor accounting is higher than the benefit to be achieved out of the change. Thus, IFRS 16 substantially carries forward the requirements under IAS 17 for accounting of lease by a lessor. Accordingly, a lessor continues to classify its leases as operating leases or finance leases (based on the criteria similar to those in IAS 17), and to account for those two types of leases differently.However, lessors will have to comply with enhanced disclosure requirements.
Separating Components of a Contract
Lease and non-lease components of a contract should be accounted for separately unless the lessee opts for a practical expedient to account for the lease component and associated non-lease components as a single lease component (election available by class of underlying asset). Where the lessee does not opt for the practical expedient, following needs to be considered:
- The lease component is accounted for under IFRS 16 whereas the non-lease component is accounted for under applicable IFRS.
- The allocation of consideration to lease and non-lease components is based on a relative standalone price.
In case of lessor, the principle for allocation of consideration is consistent with that applicable in case of lessee, i.e., allocation for lessor will be based on IFRS 15 which generally considers the relative standalone price.
Sale & Leaseback Transactions
In case of a sale and leaseback transaction, a company needs to determine whether the transfer of the asset is a sale applying the principles of IFRS 15 which is based on a ‘control’ model.
In case the transfer of the asset meets the definition of ‘sale’, the seller-lessee would account for the transaction as follows:
- recognise the sale at fair value (i.e., derecognise the underlying asset) and recognise only gain or loss that relates to the rights transferred to the buyer-lessor
- recognise the right-to-use asset at the proportion of the previous carrying amount of the asset that relates to the right of use retained by the seller-lessee and a lease liability
In case of transfer not being a sale, the seller-lessee continues to recognise the transferred asset and recognise a financial liability (under IFRS 9) for the transfer proceeds. Similarly, lessor does not recognise the transferred asset; instead it recognises a financial asset (under IFRS 9) equal to the transfer proceeds.
A lessee has entered into a 3 years’ lease for an item of a plant and machinery (having a useful life of 10 years) under which the lessee will make the following payments to the lessor (at each year-end):
Accounting for Lessee Under IAS 17
Under IAS 17, the above arrangement would be classified as an operating lease with the lease payment recognised as an expense on a straight-line basis over the lease term as follows:
Accounting for Lessee Under IFRS 16
Under IFRS 16, the lessee would account for the above arrangement using the single lease model, i.e., it would recognise a right-of-use asset and a corresponding lease liability. Assuming an interest rate implicit in the lease is 9% p.a., accounting in this case can be explained with the help of the following table:
Impact on IFRS 16 on Statement of Profit & Loss
The impact of IFRS 16 (vis-à-vis IAS 17) can be understood with the help of the following graph:
Thus, from the above, it can be concluded that the lessee accounting under IFRS 16 results in total expense being front-loaded.
IFRS 16 provides an option to the lessee to use either a full retrospective or a modified retrospective approach on transition for existing leases; however, the election needs to be applied consistently to all leases. The modified retrospective approach is a pragmatic approach provided to give cost relief to lessee. Under this approach, lessee:
- does not restate previous comparative periods
- recognises a lease liability at the present value of remaining lease payments on the transition date
- has a choice, on a lease-by-lease basis, regarding the measurement of the right-of-use asset- IASB concluded that permitting a choice should be largely ‘self-policing’ in terms of application
To further ease the costs on transition, IASB also decided to allow a lessee to elect to use one or more of the following practical expedients:
- use of a single discount rate to a portfolio of leases with reasonably similar characteristics
- reliance on previously recognised onerous lease provisions
- exemption for leases for which the lease term ends within 12 months
- exclusion of initial direct costs from measurement of right-of-use asset
- use of hindsight in applying IFRS 16, e.g., in determining the lease term if the contract contains options to extend or terminate the lease
For existing leases classified as finance leases, the lessee can carry forward the asset and lease liability under IAS 17.
Lessors are not required to make any adjustments on transition(except for intermediate lessors in a sublease).
Impact of the New Standard
IFRS 16 has a far-reaching impact not just on the company’s financial statements (including accounting manuals and key financial metrics), but also the operations and business practice of the company including:
- lease negotiation process, contract terms and business practices
- IT systems and controls
- data collection and management
- tax positions/ exposure arising from application of the new Standard
Expected Preparation Level for Companies- What They Need To Do?
Firstly, the companies need to understand the current status of the various leasing arrangements it has entered into. The companies need to identify the key impact areas of IFRS 16 on the company’s operations as well as finances and need to determine the changes in the systems and process they would incorporate after careful consideration of those impact areas including the assessment of processes for data collection, internal controls and IT systems. The various changes designed should be benchmarked against peers and others in the industry. The companies should have a detailed plan for implementation of these changes and also need to monitor the implementation at frequent intervals. It is also important for companies to communicate to, and educate, the stakeholders (shareholders, regulators, bankers, etc.) about the impact of IFRS 16 to ensure they understand the implications of the Standard on the company’s business and operations.
Mr. Akshat Kedia is a Chartered Accountant by profession. He is currently working at EY in Financial Accounting and Advisory Services. He has contributed to the ‘Auditors’ chapter of ‘Guide to the Companies Act’ by A Ramaiya (18th edition) published by LexisNexis.