1. Introduction and context setting
International Financial Reporting Standard (IFRS®) 16, Leases was issued in January 2016 and has been effective for periods beginning on or after 1 January 2019. Early adoption was also permitted for entities that applied IFRS 15, Revenue from Contracts with Customers at or before the date of initial application of IFRS 16. The purpose of this article is to summarise some of the key issues related to IFRS 16 from the perspective of the lessee and how these impact on financial reporting.
IFRS 16 replaced International Accounting Standard (IAS®) 17. 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 leases rather than finance leases in order to enable leased assets and liabilities to be left off the statement of financial position.
It was for this reason that IFRS 16 was introduced. Although the concept of operating leases and finance leases still exists from the perspective of the lessor, they do not relate to the accounting of the lessee and lessor accounting is beyond the scope of this article.
2. IFRS 16 – assets
At the inception of a contract, an entity must assess whether the contract is, or contains, a lease. This will be the case if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration.
To assess whether a contract conveys the right to control the use of an identified asset for a period of time, the lessee must have both of the following:
- the right to obtain substantially all of the economic benefits from the use of the identified asset, and
- the right to direct the use of the identified asset.
2.1 An ‘identified asset’
One essential feature of a lease is that the underlying asset (ie the asset that is the subject of the lease) is ‘identified’. 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 six-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 purpose 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, or the customer designed the asset in a way that predetermines how and for what purpose the asset will be used.
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 (ie the transportation of specified goods from London to Edinburgh within a specified timeframe) is predetermined in the contract. Although it is possible for rights to be predetermined in a contract, in this contract C does not have any decision-making rights relating to the use of the asset.
Therefore, C has the same rights regarding the use of the truck as if it were one of many customers transporting goods using the truck. In other words, C is simply paying for haulage services rather than leasing a truck.
3. Accounting for leases
With very few exceptions (see section 3.4 for further details), lessees recognise a ‘right-of-use-asset’ (ie an asset in the statement of financial position representing the right to use an underlying asset) and an associated liability at the commencement date of the lease (ie the date that the lessor makes the underlying asset available for use by the lessee).
IFRS 16 requires that the lease liability should initially be measured at the present value of the lease payments that are not paid at the commencement date. 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:
- the amount of the initial measurement of the lease liability (as described above)
- 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 at the commencement date 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 which is equivalent to a 20-year cumulative discount factor of 11.470. The present value of the 20 years of lease payments is $917,600 ($80,000 x 11.470).
The carrying amount of the right-of-use-asset at the commencement date is $942,600 ($917,600 + $25,000 initial direct costs) 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 two. This is done in the following table: