Accounting Alert - January 2016
IASB issues IFRS 16 – Leases
After years of deliberation, extensive consultation, and lively debate, the International Accounting Standards Board has now issued IFRS 16 Leases. The new standard eliminates the distinction between operating and finance leases for lessees and will result in lessees bringing most leases onto their balance sheets. The accounting by lessors will remain largely unchanged.
- Control model applied to the identification of leases, distinguishing between leases and service contracts on the basis of whether there is an identified asset controlled by the customer
- Significant changes to lessee accounting – all leases on balance sheet
- Exemptions for short-term leases and leases of low value assets
- Likely to result in:
- Change in profit / expense profile
- Front loaded expense
- Higher EBITDA and EBIT
- Impact on interest cover
- Change in balance sheet – recognition of assets and liabilities for all leases
- Higher leverage
- Change in return on asset measures
- Change in profit / expense profile
- Accounting unchanged (still classify leases as either operating or finance)
- More risk disclosures, especially relating to residual value risk
- Effective date of 1 January 2019
- Some practical expedients
IFRS 16 contains guidance on identification, recognition, measurement, presentation, and disclosure of leases by lessees and lessors.
Identifying Leases – new control model
The standard states that ‘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’. An identified asset is normally explicitly or implicitly specified at the inception of the arrangement. An entity controls the identified asset when it has the right to obtain substantially all of the economic benefits from the asset during the period of use and to direct the use of the asset. The standard provides guidance on applying these concepts of power and benefits so that entities can distinguish between leases and other service contracts.
Lessee Accounting – all leases on balance sheet
The lessee recognises a right-of-use asset and a lease liability for all leases (subject to limited exceptions for short-term leases and leases of low value assets).
The lease liability is measured initially at the present value of the future lease payments discounted at the interest rate implicit in the lease, if that rate is readily determinable, or otherwise at the incremental borrowing rate of the lessee. The initial measurement of the liability includes fixed and some variable lease payments (including for the initial lease term and any reasonably certain renewals) and amounts expected to be paid under residual value guarantees, purchase options, and termination penalties.
The liability is subsequently increased to reflect interest expense, reduced for any payments made, and remeasured for any modifications or other changes to the cash flows expected to be made under the lease.
The right-of-use asset is measured initially at the amount calculated for the lease liability plus any upfront payments made (less lease incentives received), initial direct costs incurred, and an estimate of the expense that will be required to dismantle the asset and restore the site at the end of the lease.
The right-of-use asset is subsequently measured using the cost model under IAS 16 Property, Plant and Equipment with several exceptions noted below. Depreciation expense and impairment expense, if any, are recognised through profit or loss. The carrying amount of the right-of-use asset is also adjusted for any remeasurements made to the lease liability due to reassessments and modifications.
Where the right-of-use asset meets the definition of investment property and the entity measures its investment property at fair value, the right-of-use asset is also measured at fair value. Where the right-of-use asset relates to a class of property, plant and equipment that is measured at fair value, the entity may also elect to measure the right-of-use asset at fair value.
The new standard provides guidance on presenting cash flows relating to leases in the statement of cash flows. Cash payments for the principal portion of the lease liability are to be shown as financing activities. The interest portion should be classified in a manner consistent with other interest payments. Short-term lease payments, payments for leases of low value assets, and variable lease payments not included in the initial calculation of the lease liability are shown as operating cash flows.
Under the operating lease model in IAS 17 Leases, lease payments were generally recognised on a straight-line basis over the lease term. Under the new standard the entity will recognise depreciation expense on the right-of-use asset and interest expense on the outstanding balance of the liability. This means that the expense will be more heavily weighted towards the early part of the lease period since interest expense will decrease over time as the liability is reduced. A portion of the expense relating to the lease will also shift from lease expense to interest expense. This will lead to changes in certain profit measures, such as EBITDA and EBIT, and may also impact the amounts shown as operating and financing cash flows.
For lessees with significant lease arrangements, the new standard will also result in significant changes to the balance sheet which could affect leverage measures, including in bank covenants or other contractual arrangements.
Companies will need to apply significant judgement in applying the new standard, particularly in assessing the likelihood of the entity exercising any options to extend the lease term, terminate the lease prior to the end of the lease term, or purchase the underlying asset. Leases will need to be monitored with any subsequent changes in judgements or modifications to the arrangements reflected in the right-of-use asset and lease liability.
The standard also includes additional disclosure requirements to assist users in understanding the impacts of lease arrangements on the entity.
Exemptions for Short Term and Low Value Leases
The standard makes an exception to the recognition and measurement requirements for short-term leases (less than one year) and certain low value items which are not dependent on, or interrelated with, other assets. Where the exemption applies, the lease payments may be recognised on a straight-line basis (or other systematic basis) over the lease term. ‘Low value’ is determined by reference to the value of the item, not materiality to the entity in question. There is no bright line value threshold within the standard, however the Basis for Conclusions indicates that the Board considers any standalone item worth less than USD $5,000 (when new) to be low value.
The accounting rules for lessors under IFRS 16 are substantially unchanged. Lessors will continue to distinguish between operating and finance leases with only finance leases recognised on the balance sheet. IFRS 16 includes some enhanced disclosure requirements on the lessors’ risk exposures, particularly in relation to residual value risk.
Effective Date and Transition
The new standard is effective for annual reporting periods beginning on or after 1 January 2019. Early adoption is permitted where the entity has also adopted NZ IFRS 15 Revenue from Contracts with Customers. The transition requirements include several practical expedients to reduce the costs of complying with the new standard.
IFRS 16 supersedes IAS 17 Leases, IFRIC 4 Determining whether an Arrangement contains a Lease, SIC-15 Operating Leases – Incentives, and SIC-27 Evaluating the Substance of Transactions Involving the Legal Form of a Lease.
Preparation for the Adoption of IFRS 16
Entities should review their leasing arrangements and evaluate the impact that IFRS 16 will have on their financial reporting, including an assessment of the systems and controls in place to identify, measure and report information about leases. Entities will also need to communicate with stakeholders, including shareholders and lenders, to explain the expected impact to the financial statements. Management and directors may wish to re-examine bank covenants, management incentive schemes or other contracts that may be impacted by changes to the financial statements. Additionally, consideration of the accounting treatment for any new leases at the time those agreements are being negotiated may ease the process of transitioning to the new standard.
Deloitte global guidance – available on our IAS Plus IFRS 16 resources page
- Overview of the project history
- IFRS in Focus: IASB Issues IFRS 16 - Leases
- Interviews with IASB Chairman Hans Hoogervorst and Deloitte Global IFRS Leader Veronica Poole
- The Bruce Column - Bringing clarity to leases: The new standard
- IFRS industry insights newsletters: