IFRS 16 (LEASE) {Key Notes on IFRS 16}

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We can have valuable discussion on IFRS 16, Lets Connect..... how is it applicable ? Initial Measurement ? Subsequent Measurement (Lessee & Lesser point of view), Accounting Treatment in both holder books ? Lease Modification ? Sale & Lease Back ? Covid 19 related rent concession.

The impact of the new leases standard

·        The IASB published IFRS 16 Leases in January 2016 with an effective date of 1 January 2019. The new standard requires lessees to recognise nearly all leases on the balance sheet which will reflect their right to use an asset for a period of time and the associated liability for payments.

RIGHT TO USE AN ASSEST=ASSOCIATED LIAB FOR PMT

·        Leasing is an important and widely used financing solution. It enables companies to access and use property and equipment without incurring large cash outflows at the start

·        Under existing rules, lessees account for lease transactions either as operating or as finance leases, depending on complex rules and tests which, in practice, use ‘bright-lines’ resulting in all or nothing being recognised on balance sheet for sometimes economically similar lease transactions.

Existing Rules: Lessee may recognized lease transaction as Operating or Finance Lease, however in the amended rule: No Operating lease for lessee

·        The impact on a lessee’s financial reporting, asset financing, IT, systems, processes and controls is expected to be substantial. Many companies lease a vast number of big-ticket items, including cars, offices, power plants, retail stores, cell towers and aircraft.

Impact on Lessee:

·        The new standard 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, EPS, ROCE, ROE 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.

·        Balance sheets will grow, gearing ratios will increase, and capital ratios will decrease. There will also be a change to both the expense character (rent expenses replaced with depreciation and interest expense) and recognition pattern (acceleration of lease expense relative to the recognition pattern for operating leases today).

·        Entities leasing ‘big-ticket’ assets – including real estate, manufacturing equipment, aircraft, trains, ships, and technology – are expected to be greatly affected. The impact for entities with numerous small leases, such as tablets and personal computers, small items of office furniture and telephones might be less as the IASB offers an exemption for low value assets (assets with a value of $5,000 or less when new). Low value assets meeting this exemption do not have to be recognised on the balance sheet.

·        The cost to implement and continue to comply with the new leases standard could be significant for most lessees. Particularly if they do not already have an in-house lease information system.

Impact on Lessors:

·        Business and legal structures supporting leases should also be reassessed to evaluate whether these continue to be effective (for example, joint ventures and special purpose entities).

·        Lessor accounting remains largely unchanged from IAS 17 however, lessors are expected to be affected due to the changed needs and behaviours from customers which impacts their business model and lease products

Lease or Non Lease Component:

Lease Component                 :                 Lessor=Lessee

Non Lease Component :                 Service Provider=Receiver

·        Both lessors and lessees are required to determine if a right to use an underlying asset is a separate lease component in their contracts if both of the following criteria are met:

o  The lessee can benefit from use of the asset either on its own or together with other resources that are readily available to the lessee. Readily available resources are goods or services that are sold or leased separately (by the lessor or other suppliers) or resources that the lessee has already obtained (from the lessor or from other transactions or events) and

o  The underlying asset is neither dependent on, nor highly interrelated with, the other underlying assets in the contract.

·        After the identification of components in a contract, payments should be allocated as follows:

o  Lessors should apply the guidance in IFRS 15 Revenue from Contracts with Customers when allocating the transaction price to separate components. Allocation is based on the relative standalone selling prices (SSP). If no observable information is available, entities are required to estimate the SSP. IFRS 15 distinguishes three methods of estimation: adjusted market assessment approach, expected cost plus margin approach and residual approach. Entities may want to combine the adoption of the new leases standard with the new revenue recognition standard (effective 1 January 2018), considering the interdependencies between the two standards. This may prove to be the most cost-efficient

o  Lessees should separate lease components from non-lease components unless they apply the accounting policy election described below. Activities that do not transfer a good or service to the lessee are not components in a contract. Allocation of payments should be similar to lessors as described above. The standard gives the policy election for lessees to not separate non-lease components from a lease component for a class of an underlying asset. In such cases, the whole contract is accounted for as a lease.

Financial Statement of Lessee:

On Assets Side:   Right to use of lease assets

On Liabilities Side:      Associated Liability for Payment (Lease Liab)

On Expense Side:        Interest Expense and Depreciation on Lease Assets

·        Lessees should initially recognise a right-of-use asset and lease liability based on the discounted payments required under the lease, taking into account the lease term as determined under the new standard.

·        The right-of-use asset is initially measured at the amount of the lease liability plus any initial direct costs incurred by the lessee. Adjustments may also be required for lease incentives, payments at or prior to commencement and restoration obligations or similar, [IFRS 16:24}

·        After lease commencement, a lessee shall measure the right-of-use asset using a cost model, unless: [IFRS 16:29, 34, 35]

o  the right-of-use asset is an investment property and the lessee fair values its investment property under IAS 40; or

o  the right-of-use asset relates to a class of PPE to which the lessee applies IAS 16’s revaluation model, in which case all right-of-use assets relating to that class of PPE can be revalued.

o  Under the cost model a right-of-use asset is measured at cost less accumulated depreciation and accumulated impairment. [IFRS 16:30(a)]

·        A ‘right-of-use’ model replaces the ‘risks and rewards’ model. Lessees are required to recognise an asset and liability at the inception of a lease.

·        All lease liabilities are to be measured with reference to an estimate of the lease term, which includes optional lease periods when an entity is reasonably certain to exercise an option to extend (or not to terminate) a lease.

·        The lease liability is initially measured at the present value of the lease payments payable over the lease term, discounted at the rate implicit in the lease if that can be readily determined. If that rate cannot be readily determined, the lessee shall use their incremental borrowing rate. [IFRS 16:26]

·        Lessees should reassess the lease term only upon the occurrence of a significant event or a significant change in circumstances that are within the control of the lessee.

Let me outline the journal entry:

1         Lessee takes an asset under the lease:

·        Debit Right-of-use asset

·        Credit Lease liability (in the amount of the lease liability)

2         Lessee pays the legal fees for negotiating the contract:

·        Debit Right-of-use asset

·        Credit Suppliers

3         The estimated cost of removal, discounted to present value (lessee will need to remove an asset and restore the site after the end of the lease term):

·        Debit Right-of-use asset

·        Credit Provision for asset removal (under IAS 37)

Subsequent measurement

·        After commencement date, lessee needs to take care about both elements recognized initially:

1. Right-of-use asset
2. Normally, a lessee needs to measure the right-of-use asset using a cost model under IAS 16 Property, Plant and Equipment.It basically means to depreciate the asset over the lease term:

o   Debit Profit or loss – Depreciation charge

o   Credit Accumulated depreciation of right-of-use asset

However, the lessee can apply also IAS 40 Investment Property (if the right-of –use asset is an investment property and fair value model is applied), or using revaluation model under IAS 16 (if right-of-use asset relates to the class of PPE accounted for by revaluation model).

1. Lease liability
2. A lessee needs to recognize an interest on the lease liability:

o   Debit Profit or loss – Interest expense

o   Credit Lease liability

Also, the lease payments are recognized as a reduction of the lease liability:

o   Debit Lease liability

o   Credit Bank account (cash)

If there is a change in the lease term, lease payments, discount rate or anything else, then the lease liability must be re-measured to reflect all the changes.

Financial Statement of Lessor

·        Lessors shall classify each lease as an operating lease or a finance lease. [IFRS 16:61]

·        A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset. Otherwise a lease is classified as an operating lease. [IFRS 16:62]

·        Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are: [IFRS 16:63]

• The lease transfers ownership of the asset to the lessee by the end of the lease term.
• The lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date of the option exercisability. It is reasonably certain, at the inception of the lease, that the option will be exercised.
• The lease term is for the major part of the economic life of the asset even if the title is not transferred.
• At the inception of the lease the present value of the lease payments amounts to at least substantially all of the fair value of the leased asset.
• The leased assets are of such a specialized nature that only the lessee can use them without major modifications.

·        Upon lease commencement, a lessor shall recognise assets held under a finance lease as a receivable at an amount equal to the net investment in the lease. [IFRS 16:67]

·        The journal entry is as follows:

·        Debit Lease receivable

·        Credit PPE (underlying asset)

·        A lessor recognises finance income over the lease term of a finance lease, based on a pattern reflecting a constant periodic rate of return on the net investment. [IFRS 16:75]

·        Lessors should apply the guidance in IFRS 15 Revenue from Contracts with Customers when allocating the transaction price to separate components.

·        Allocation is based on the relative standalone selling prices (SSP). If no observable information is available, entities are required to estimate the SSP.

·        IFRS 15 distinguishes three methods of estimation: adjusted market assessment approach, expected cost plus margin approach and residual approach.

·       Subsequent Measurement

The lessor should recognize:

1. A finance income on the lease receivable:

• Debit Lease receivable
• Credit Profit or loss – Finance income

1. A reduction of the lease receivable by the cash/bank received:

• Debit Bank account (Cash)
• Credit Lease receivable

Sale and leaseback transactions:

·        To determine whether the transfer of an asset is accounted for as a sale an entity applies the requirements of IFRS 15 for determining when a performance obligation is satisfied. [IFRS 16:99]

·        If an asset transfer satisfies IFRS 15’s requirements to be accounted for as a sale the seller measures the right-of-use asset at the proportion of the previous carrying amount that relates to the right of use retained. Accordingly, the seller only recognises the amount of gain or loss that relates to the rights transferred to the buyer. [IFRS 16:100a)]

·        If the fair value of the sale consideration does not equal the asset’s fair value, or if the lease payments are not market rates, the sales proceeds are adjusted to fair value, either by accounting for prepayments or additional financing. [IFRS 16:101]

·        Accounting treatment of sale and leaseback transactions depends on the whether the transfer of an asset is a sale under IFRS 15 Revenue from contracts with customers.

1. If a transfer is a sale:

• The seller (lessee) accounts for the right-of-use asset at the proportion of the previous carrying amount related to the right-of-use retained. Gain or loss is recognized only to the extend related to the rights transferred. (IFRS 16, par.100)
• The buyer (lessor) accounts for a purchase of an asset under applicable standards and for the lease under IFRS 16.

1. If a transfer is NOT a sale:

• The seller (lessee) keeps recognizing transferred asset and accounts for the cash received as for a financial liability under IFRS 9 Financial Instruments.
• The buyer recognizes a financial asset under IFRS 9 amounting to the cash paid.

Short-term leases:

·        Under IFRS 16 lessees may elect not to recognise assets and liabilities for leases with a lease term of 12 months or less. In such cases a lessee recognises the lease payments in profit or loss on a straight-line basis over the lease term. The exemption is required to be applied by class of underlying assets.

Lease of Low Value Assets:

·        Lessees are not required to recognise assets or liabilities for leases of low value assets such as tablets and personal computers, small items of office furniture and telephones. The IASB has included in the Basis of Conclusions an indicative amount of less than $5,000 when new as the value of assets that would normally qualify for the exemption.

nterest rate implicit in the lease

Covid-19-related rent concessions 

·        A lessee may elect not to assess whether a COVID-19-related rent concession is a lease modification. A lessee that that applies the exemption accounts for COVID-19-related rent concessions as if they were not lease modifications. [IFRS 16:46A, 46B]