IFRS 16 - Lease Accounting & Reporting

In January 2016, IASB issued another important and long-discussed standard: IFRS 16 Leases that will replace IAS 17. As we know that under IAS 17, lessees needed to classify the lease as either finance or operating. However if the lease was classified as operating, then the lessees showed neither asset nor liability in their balance sheets and it was considered as an off BS items but just showing the lease payments as an expense in profit or loss. However some operating leases were non-cancellable, and therefore, they represented a liability (and an asset) for the lessees. This liability was hidden from the readers of the financial statements, as it was not presented anywhere. Though some disclosures in the notes to the financial statements were mandatory but not sufficient to compare the financials of the entity who capitalize the similar lease as finance lease. The purpose of new IFRS 16 to removes this discrepancy and puts most leases on balance sheet.

The main difference between IFRS 9 & IAS 17 are as below:

SL NO

Category

IAS 17

IFRS 16

1. Focus

The focus is on who bears the risks and the rewards of the lease

The focus is on who has the right to use the asset

2. Recognition of Lease

Finance leases are recognized as assets and operating leases are recognized as expenses

All leases are recognized as assets except few exception.

3. Accounting treatment

The accounting treatment of operating leases is less complex than the treatment of finance leases and the volume of operating leases is predominantly higher than that of finance leases. So, currently, accounting departments have a lower volume of the challenging calculations to make

As all leases will be treated under the same accounting treatment, accounting departments will have a higher volume of complex amortization calculations to perform.

4. Comparison

It is difficult to compare company’s financial statements (FS) who lease with those who buy 

Improved comparability and transparency on BS. FS users can clearly see the effect of operating lease and have a useful basis for comparability with the other companies

5. Split of Rent / Lease charges

Do not need to split services charges (AMC) with rent as both go to P&L in case of operating lease

We need to split AMC charges with rent so that we can do separate accounting.

IFRS 16 is effective for reporting periods beginning on or after 1 January 2019. Earlier application is permitted, but only in conjunction with IFRS 15. This means that an entity is not allowed to apply IFRS 16 before applying IFRS 15. The date of initial application is the beginning of the annual reporting period in which an entity first applies IFRS 16. So lets go through the IFRS 16 in detail.

IFRS 16 defines a lease as a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. 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.

For example, an entity might want to transport a specified quantity of goods, in accordance with a stated timetable, for a period of five years from A to B by rail. To achieve this, it could either rent a number of rail cars or it could contract to buy the transport service from a freight carrier. In both cases, the goods will arrive at B – but the accounting might be quite different!

Leases are different from service contracts: a lease provides a customer with the right to control the use of an asset; whereas, in a service contract, the supplier retains control.

IFRS 16 states that a contract contains a lease if:

·        There is an identified asset; and

·        The contract conveys the right to control the use of the identified asset for a period of time in exchange for consideration.

An asset can be identified asset either explicitly or implicitly. If explicit, the asset is specified in the contract (for example, by a serial number or a similar identification marking); if implicit, the asset is not mentioned in the contract (so the entity cannot identify the particular asset) but the supplier can fulfil the contract only by the use of a particular asset. In both cases there may be an identified asset. In any case, there is no identified asset if the supplier has a substantive right to substitute the asset. Substitution rights are substantive where the supplier has the practical ability to substitute an alternative asset and would benefit economically from substituting the asset.

A contract conveys the right to control the use of an identified asset if the customer has both the right to obtain substantially all of the economic benefits from use of the identified asset and the right to direct the use of the identified asset throughout the period of use.

As a simple illustration, let me come up with a small example:

Imagine you want to rent some space in the warehouse for storing your goods. You’d like to enter into a 3-year rental contract. The owner of that warehouse offers 2 options to you:

1. You will occupy a certain area of XY cubic meters, but the specific place will be determined by the owner of the warehouse, based on actual usage of the warehouse and free storage.

2. You will occupy the unit no. 13 of XY cubic meters in the sector A of that warehouse. This place is assigned to you and no one can change it during the duration of the contract.

Both contracts look like lease contracts, and indeed, in both cases, you would book the rental payments an expense in profit or loss under older IAS 17. However from IFRS 16 perspective:

1.      The first contract does not contain any lease, because no asset can be identified.

 The reason is that the supplier (warehouse owner) can exchange one place for another and you lease only certain capacity. Therefore, you would account for rental payments as for expenses in profit or loss.

2.      The second contract does contain a lease, because an underlying asset can be identified– you are leasing the unit no. 13 of XY cubic meters in the sector A.

Therefore, you need to account for this contract as for the lease and it means recognizing some asset and a liability in your balance sheet. This was a very simplified illustration to make you aware of this and it’s by no means exhaustive – but you get a point.

Further under new IFRS 16, you need to split the rental or lease payments into lease element and non-lease element, because you need to:

·        Account for a lease element as for a lease under IFRS 16 (if it meets the criteria in IFRS 16); and

·        Account for a service element as before, in most cases as an expense in profit or loss.

From our example above: let’s say you took the option 2 and you pay CU 10,000 per year. This payment includes the payment for rental of the unit no. 13 and its cleaning once per week.

Therefore, you need to split the payment of CU 10,000 into lease element and cleaning element based on their relative stand-alone selling prices (i.e. for similar contracts when got separately).

You find out that you would be able to rent out similar unit in the warehouse next door for CU 9,000 per year without cleaning service, and you would need to pay CU 1,500 per year for its cleaning.

Based on this, you need to:

·        Allocate CU 8,571 (CU 9,000/ (CU 9,000+CU 1,500)) to the lease element and account for that as for the lease; and

·        Allocate CU 1,429 (CU 1,500/ (CU 9,000+CU 1,500)) to the service element and in this case, probably recognize it in profit or loss as an expense for cleaning.

Not an easy thing, especially when the stand-alone selling prices are not readily available.

Another biggest change is that lessees (those who take an asset under lease) do not need to classify the lease at its inception and determine whether it’s finance or operating.

The reason is that IFRS 16 prescribes a single model of accounting for every lease for the lessees. Very shortly:

·        Lessee needs to recognize a right-of-use asset and corresponding liability in its statement of financial position.

·        An asset shall be depreciated and a liability amortized over the lease term.

This model is very similar to the accounting for finance leases under IAS 17. There are 2 exceptions from this rule. (a) Lease of assets for less than 12 months (short-term leases) & (b) Lease of assets of a low value (such as computers, furniture etc.). Accounting for leases by lessors almost does not change, so they can continue in the same way.

Thus we can say that new lease standard will have significant impact on the companies heavily working with operating leases. The financial indicators of these companies can substantially change, because new assets and liabilities are coming to the balance sheet. Also, many lessees will have a hard time to set up a system of gathering and analyzing enough information to satisfy new requirements.