1. Introduction and context setting
International Financial Reporting Standard (IFRS®) 16 – Leases – was issued in January 2016 and, in comparison to its predecessor International Accounting Standard (IAS®) 17 makes significant changes to the way in which leasing transactions are reported in the financial statements of lessees (although not in the financial statements of lessors). The purpose of this article is to summarise the key changes introduced by IFRS 16 from the perspective of the lessee and how these impact on their financial reporting.
A lease is an agreement whereby the lessor (the legal owner of an asset) conveys to the lessee (the user of the asset) the right to use an asset for an agreed period of time in return for a payment or series of payments.
The approach of IAS 17 was to distinguish between two types of lease. Leases that transfer substantially all the risks and rewards of ownership of an asset were classified as finance leases. All other leases were classified as operating leases. The lease classification set out in IAS 17 was subjective and there was a clear incentive for the preparers of lessee’s financial statements to ‘argue’ that leases should be classified as operating rather than finance leases in order to enable leased assets and liabilities to be left out of the financial statements.
It was for this reason that IFRS 16 was introduced.
2. IFRS 16 – assets
IFRS 16 defines a lease as “A contract, or part of a contract, that conveys the right to use an asset for a period of time in exchange for consideration”. In order for such a contract to exist the user of the asset needs to have the right to:
- Obtain substantially all of the economic benefits from the use of the asset.
- The right to direct the use of the asset.
2.1 An ‘identified asset’
One essential feature of a lease is that there is an ‘identified asset’. This normally takes place through the asset being specified in a contract, or part of a contract. For the asset to be ‘identified’ the supplier of the asset must not have the right to substitute the asset for an alternative asset throughout its period of use. The fact that the supplier of the asset has the right or the obligation to substitute the asset when a repair is necessary does not preclude the asset from being an ‘identified asset’.
Example – identified assets
Under a contract between a local government authority (L) and a private sector provider (P), P provides L with 20 trucks to be used for refuse collection on behalf of L for a 6-year period. The trucks, which are owned by P, are specified in the contract. L determines how they are used in the refuse collection process. When the trucks are not in use, they are kept at L’s premises. L can use the trucks for another purposes if it so chooses. If a particular truck needs to be serviced or repaired, P is required to substitute a truck of the same type. Otherwise, and other than on default by L, P cannot retrieve the trucks during the six-year period.
Conclusion: The contract is a lease. L has the right to use the 20 trucks for six years which are identified and explicitly specified in the contract. Once delivered to L, the trucks can be substituted only when they need to be serviced or repaired.
2.2 The right to direct the use of the asset
IFRS 16 states that a customer has the right to direct the use of an identified asset if either:
- The customer has the right to direct how and for what purpose the asset is used throughout its period of use; or
- The relevant decisions about use are pre-determined and the customer has the right to operate the asset throughout the period of use without the supplier having the right to change these operating instructions.
Example – the right to direct the use of an asset
A customer (C) enters into a contract with a road haulier (H) for the transportation of goods from London to Edinburgh on a specified truck. The truck is explicitly specified in the contract and H does not have substitution rights. The goods will occupy substantially all of the capacity of the truck. The contract specifies the goods to be transported on the truck and the dates of pickup and delivery.
H operates and maintains the truck and is responsible for the safe delivery of the goods. C is prohibited from hiring another haulier to transport the goods or operating the truck itself.
Conclusion: This contract does not contain a lease.
There is an identified asset. The truck is explicitly specified in the contract and H does not have the right to substitute that specified truck.
C does have the right to obtain substantially all of the economic benefits from use of the truck over the contract period. Its goods will occupy substantially all of the capacity of the truck, thereby preventing other parties from obtaining economic benefits from use of the truck.
However, C does not have the right to control the use of the truck because C does not have the right to direct its use. C does not have the right to direct how and for what purpose the truck is used. How and for what purpose the truck will be used (i.e. the transportation of specified goods from London to Edinburgh within a specified timeframe) is predetermined in the contract. C has the same rights regarding the use of the truck as if it were one of many customers transporting goods using the truck.
3. Accounting for leases
With a very few exceptions (see section 3.4 for further details) IFRS 16 abolishes the distinction between an operating lease and a finance lease in the financial statements of lessees. Lessees will recognise a right of use asset and an associated liability at the inception of the lease.
IFRS 16 requires that the ‘right of use asset’ and the lease liability should initially be measured at the present value of the minimum lease payments. The discount rate used to determine present value should be the rate of interest implicit in the lease.
3.1 Recording the asset
The ‘right of use asset’ would include the following amounts, where relevant:
- Any payments made to the lessor at, or before, the commencement date of the lease, less any lease incentives received.
- Any initial direct costs incurred by the lessee.
- An estimate of any costs to be incurred by the lessee in dismantling and removing the underlying asset, or restoring the site on which it is located (unless the costs are incurred to produce inventories, in which case they would be accounted for in accordance with IAS 2 – Inventories). Costs of this nature are recognised only when an entity incurs an obligation for them. IAS 37 – Provisions, Contingent Liabilities and Contingent Assets would be applied to ascertain if an obligation existed.
The right of use asset is subsequently depreciated. Depreciation is over the shorter of the useful life of the asset and the lease term, unless the title to the asset transfers at the end of the lease term, in which case depreciation is over the useful life.
3.3 Lease liability
The lease liability is effectively treated as a financial liability which is measured at amortised cost, using the rate of interest implicit in the lease as the effective interest rate.
Example – accounting for leases
A lessee enters into a 20-year lease of one floor of a building, with an option to extend for a further five years. Lease payments are $80,000 per year during the initial term and $100,000 per year during the optional period, all payable at the end of each year. To obtain the lease, the lessee incurred initial direct costs of $25,000
At the commencement date, the lessee concluded that it is not reasonably certain to exercise the option to extend the lease and, therefore, determined that the lease term is 20 years. The interest rate implicit in the lease is 6% per annum. The present value of the lease payments is $917,600.
At the commencement date, the lessee incurs the initial direct costs and measures the lease liability $917,600.
The carrying amount of the right of use asset after these entries is $942,600 ($917,600 + $25,000) and consequently the annual depreciation charge will be $47,130 ($942,600 x 1/20).
The lease liability will be measured using amortised cost principles. In order to help us with the example in the following section, we will measure the lease liability up to and including the end of year ten. This is done in the following table:
|Finance cost (6%)
At the end of year one, the carrying amount of the right of use asset will be $895,470 ($942,600 less $47,130 depreciation).
The interest cost of $55,056 will be taken to the statement of profit or loss as a finance cost.
The total lease liability at the end of year one will be $892,656. As the lease is being paid off over 20 years, some of this liability will be paid off within a year and should therefore be classed as a current liability.
To find this figure, we look at the remaining balance following the payment in year two. Here, we can see that the remaining balance is $866,215. This will represent the non-current liability, being the amount of the $892,656 which will still be outstanding in over a year. The current liability element is therefore $26,441. This represents the $80,000 paid in year two less year two’s finance costs of $53,559 (or $892,656-$866,215).
3.4 A simplified approach for short-term or low-value leases
A short-term lease is a lease that, at the date of commencement, has a term of 12 months or less. A lease that contains a purchase option cannot be a short-term lease. Lessees can elect to treat short-term leases by recognising the lease rentals as an expense over the lease term rather than recognising a ‘right of use asset’ and a lease liability. The election needs to be made for relevant leased assets on a ‘class-by-class’ basis. A similar election – on a lease-by-lease basis – can be made in respect of ‘low value assets’.
The assessment of whether an underlying asset is of low value is performed on an absolute basis. Leases of low-value assets qualify for the simplified accounting treatment explained above regardless of whether those leases are material to the lessee. The assessment is not affected by the size, nature or circumstances of the lessee. Accordingly, different lessees are expected to reach the same conclusions about whether a particular underlying asset is of low value.
An underlying asset can be of low value only if:
(a) The lessee can benefit from use of the underlying asset on its own or together with other resources that are readily available to the lessee; and
(b) The underlying asset is not highly dependent on, or highly interrelated with, other assets.
A lease of an underlying asset does not qualify as a lease of a low-value asset if the nature of the asset is such that, when new, the asset is typically not of low value. For example, leases of cars would not qualify as leases of low-value assets because a new car would typically not be of low value.
Examples of low-value underlying assets can include tablet and personal computers, small items of office furniture and telephones.
4. Sale and leaseback transactions
The treatment of sale and leaseback transactions depends on whether or not the ‘sale’ constitutes the satisfaction of a relevant performance obligation under IFRS 15 – Revenue from Contracts with Customers. The relevant performance obligation would be the effective ‘transfer’ of the asset to the lessor by the previous owner (now the lessee).
4.2 Transaction constituting a sale
If the transaction does constitute a ‘sale’ under IFRS 15 then the treatment is as follows:
- the seller-lessee shall recognise only the amount of any gain or loss that relates to the rights transferred to the buyer-lessor.
- The buyer-lessor shall account for the purchase of the asset applying applicable Standards, and for the lease applying the lessor accounting requirements in IFRS 16 (these being essentially unchanged from the predecessor standard).
If the fair value of the consideration for the sale of an asset does not equal the fair value of the asset, or if the payments for the lease are not at market rates, an entity shall make the following adjustments to measure the sale proceeds at fair value:
- Any below-market terms shall be accounted for as a prepayment of lease payments; and
- Any above-market terms shall be accounted for as additional financing provided by the buyer-lessor to the seller-lessee.
Example – sale and leaseback
Entity X sells a building to entity Y for cash of $5 million. Immediately before the transaction, the carrying amount of the building in the financial statements of entity X was $3.5 million. At the same time, X enters into a contract with Y for the right to use the building for 20 years, with annual payments of $200,000 payable at the end of each year. The terms and conditions of the transaction are such that the transfer of the building by X satisfies the requirements for determining when a performance obligation is satisfied in IFRS 15 – Revenue from Contracts with Customers. Accordingly, X and Y account for the transaction as a sale and leaseback.
The fair value of the building at the date of sale is $4.5 million. Because the consideration for the sale of the building is not at fair value, X and Y make adjustments to measure the sale proceeds at fair value. The amount of the excess sale price of $500,000 ($5 million – $4.5 million) is recognised as additional financing provided by Y to X.
The annual interest rate implicit in the lease is 5%. The present value of the annual payments (20 payments of $200,000, discounted at 5%) amounts to $2,492,400, of which $500,000 relates to the additional financing and $1,992,400 ($2,492,200 – $500,000) relates to the lease (as adjusted for the fair value difference already identified). The annual payment that would be required to be made 20 times in arrears to repay additional financing of $500,000 when the rate of interest is 5% per annum would be $40,122 ($500,000/12.462 (the cumulative discount factor for 5% for 20 years)). Therefore the residual would be regarded as a ‘lease rental’ at an amount of $159,878 ($200,000 – $40,122).
Given the IFRS 15 treatment as a ‘sale’ B would almost certainly regard the lease of the building as an operating lease. This means that B would recognise the ‘lease rentals’ of $159,878 as income.
4.3 – Transaction not constituting a ‘sale’
In these circumstances the seller does not ‘transfer’ the asset and continues to reconise it, without adjustment. The ‘sales proceeds’ are recognised as a financial liability and accounted for by applying IFRS 9 – Financial Instruments. In the same circumstances, the buyer recognizes a financial asset equal to the ‘sales proceeds’.
The requirements of IFRS 16 will have significant impacts on key accounting ratios of lessees. The greater recognition of leased assets and lease liabilities on the statement of financial position will reduce return on capital employed and increase gearing. Initial measures of profit are likely to be reduced, as in the early years of a lease the combination of depreciation of the right of use asset and the finance charge associated with the lease liability will exceed the lease rentals (normally charged on a straight-line basis).